Tarun Das Adb Nepal Inception Report-Update-Text

8/9/2019 Tarun Das Adb Nepal Inception Report-Update-Text

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Nepal Macroeconomic Model- Inception Report

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INCEPTION REPORT:

NEPAL MACROECONOMIC MODEL (NMEM) AND

DYNAMIC STOCHASTIC GENERALEQUILIBRIUM (DSGE) MODEL-

MODEL STRUCTURES, DATA BASE, AND SOFTWARE-HARDWARE REQUIREMENTS

PART-I: MAIN REPORT

DR. TARUN DAS1,2

(FORMERLY, ECONOMIC ADVISER, MINISTRYOF FINANCE, INDIA)

INASSOCIATIONWITH

PROFESSOR DURGA LAL SHRESTHA3

DR. VIKASH RAJ SATYAL4

MR. ROJAN BAJRACHARYA5

8 OCTOBER2009

Executing Agency:

The Nepal Rastra Bank,

Baluwater, Kathmandu.

For any clarifications, write to: [email protected]

1 Macroeconomic Modeling Specialist/ Team Leader (International).

2 Authors would like to express their sincere thanks to Mr. Shahid Parwez, ADB Project/ ProgramImplementation Officer and Dr. Nephil Matangi Maskay, Director (Research), Nepal Rastra Bank foroverall guidance, valuable discussions and comments on an earlier draft. However, the Report expressespersonal views of the authors and does not necessarily imply the views of the ADB Nepal ResidentMission, NRB, MOF and the CBS, Nepal.

3 Macroeconomic Modeling Specialist (National)4 Econometrician (National)5 Information Technology Specialist (National)

1
mailto:[email protected]://flagspot.net/images/n/np)2006.gifmailto:[email protected]


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Table of Contents

Table of Contents Pages

Contents 3-4

Acronyms and Abbreviations 5Project Team 6

Acknowledgements 7

Nepal at a Glance by the World Bank 8-9

1. INTRODUCTION- SCOPE, BACKGROUNDAND OUTLINE

1.1 CHARACTERISTICSOFAN IDEAL MACROECONOMIC MODEL

1.2 Background of the project1.3 Meeting with ADB Project Implementation Officer,1.4 Meeting with Nepal Rastra Bank1.5 Implementation and Institutional Arrangements

1.6 An Outline of the Report

10-13

1011111212

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2. ECONOMIC CONTEXTOF MODELING

2.1 GLOBAL FINANCIAL-FOOD-FUEL CRISIS2.2 IMPACTON NEPALS ECONOMIC GROWTH

14-17

1416

3. RECENT ECONOMIC DEVELOPMENTIN NEPAL

3.1 ACHIEVEMENTSOFTHE TENTHPLAN (2002/03-2007/08)3.2 THREE YEARINTERIM PLAN (2007/08 TO 2009/10)3.3 SOCIAL DEVELOPMENT INDICATORS

3.4 EXTERNAL DEBT SITUATION3.5 ECONOMIC OUTLOOK, PROBLEMSAND PROSPECTS3.6 DEVELOPMENT CHALLENGES AND ISSUES3.7 STRENGTHS, WEAKNESS, OPPORTUNITIES, THREATS

17-23

171819

20202123

4.0 BUILDING UPAN OPERATIONAL MACROECONOMIC MODEL

4.1 BASIC PURPOSEAND DIMENSIONSOFTHE MODEL4.2 ALTERNATIVE MACROECONOMIC MODELS4.3 INTERNATIONAL BEST PRACTICESAND LESSONSFORNEPAL

4.4 DATA BASE

24-27

24252627

5. BRIEF REVIEWOF PAST MACROECONOMIC MODELLINGEXERCISES FORNEPAL

28-29

6. ANALYTICAL FRAMEWORKOFA GENERAL MACROECONOMIC MODEL

FORNEPAL

6.1 BASIC OBJECTIVES6.2 MODEL STRUCTUREAND ANALYTICAL FRAMEWORK6.3 SPECIFICATIONOFTHE MODELANDTHE WORKPLAN

30-35

303135

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7. BRIEF DESCRIPTIONSOF WORKS

7.1 UPDATINGADBMACROECOMICMODEL7.2 BUILDNGUPDSGEMODEL7.3 CAPACITYBUILDINGANDTRANING

7.4 SUPPORT ITGROUPFORSOFTWARE/HARDWARESELECTION7.5 PREPARING MANUALS AND ORGANIZING WORKSHOPS

7.6 PREPARATIONOFTHEINCEPTION REPORT7.7 PREPARATIONOF QUARTERLY PROGRESS REPORTS7.8 PREPARATIONOF TERMINAL REPORTAND ROLL OUT PLAN

36-39

363737

3739393939

8. REVIEWAND UPGRADINGTHE NEPAL MACROECONOMIC MODEL 40-53

9. DEVELOPMENTOFAN OPERATIONAL DYNAMIC STOCHASTIC GENERAL

EQUILIBRIUM MODEL (DSGE) FORNEPAL

54-61

10. RECOMMENDATIONFORCHOICEOF HARDWAREAND SOFTWAREREQUIREMENTSTO RUNTHE MODELS

62-72

REFERENCES 73-77

PART-II: ANNEXES 1-63

TABLEOF CONTENTS 3

ANNEX-1: COUNTRY ECONOMIC INDICATORS 4

ANNEX-2: COUNTRY POVERTYAND SOCIAL INDICATORS 5

ANNEX-3: SCOPE, CHARACTERISTICSAND TYPESOF MACROECONOMICMODELS

6-20

ANNEX-4: DATABASEREQUIREDFORTESTANDCALIBRATIONSOFTHENMEM AND DSGE-TYPE MODELSFORNEPAL

21-25

ANNEX-5: TERMSOFREFERENCEOFTHECONSULTANTS 26-27

ANNEX-6: BRIEFCVOFTHECONSULTANTS

28-31

ANNEX-7: WORKPLAN MATRIX OF CONSULTANTS

32-36

ANNEX-8A: BROAD FEATURESOF E-VIEWS 6 SOFTWARE 37-56

ANNEX-8B: EVIEWS COMMERCIALAND GOVERNMENT VOLUME LICENSINGCONDITIONSAND PRICES

57-62

ANNEX-9: LISTOF OFFICERS CONSULTED 63

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Acronyms and Abbreviations

ANA: Annual National AccountsCBS: Central Bureau of StatisticsCNSP: Consolidated National Statistical PlanDSGE: Dynamic Stochastic General Equilibrium

EA: Executing AgencyEDPs : External Development PartnersEFA : Education for AllEU : European UnionFAO : Food and Agriculture OrganizationFDI : Foreign Direct InvestmentFTA : Free Trade AreaFY : Fiscal YearGDI : Gender Development IndexGDP : Gross Domestic ProductGNP : Gross National ProductHDI : Human Development Index

HDR: Human Development Report/ UNDPHHs : House HoldsHIPC : Heavily Indebted Poor CountriesHIV : Human Immuno-deficiency VirusHRD : Human Resource DevelopmentILO : International Labor OrganizationIMF : International Monetary FundLDCs : Least Developed CountriesMDGs : Millennium Development GoalsMOF : Ministry of Finance/NepalMTEF : Medium Term Expenditure FrameworkNGOs : Non-Governmental Organizations

NMEM : Nepal Macro Economic ModelNPC : National Planning Commission/NepalNRB : Nepal Rastra BankODA : Official Development AssistancePPP : Purchasing Power ParityPRGF : Poverty Reduction and Growth Facility/IMFPRSP : Poverty Reduction Strategy PaperRs. : Rupees/NepaleseTA technical assistanceUK : United KingdomUN : United NationsUNDP : United Nation's Development Program

WB : World BankWDR : World Development Report/WBWFP : World Food ProgramWHO : World Health OrganizationWTO : World Trade Organization

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ADB Project on Macroeconomic Modeling for Nepal

Project Team and Supervisors

Program/ Project Implementation Officer Mr. Shahid Parwez,

ADB Nepal Residence Office

Executive Agency Nepal Rastra Bank

Overall Guidance and

Strategic Direction

Steering Committee, chaired by therelevant NPC Member and comprisingrepresentatives of MOF, NRB, and otherrelevant line ministries and departments.

Technical Advice and Supervision Technical Committee, chaired byMr. Ravindra Prasad Pandey, the

Executive Director of the ResearchDepartment of NRB, and comprisingrepresentatives of MOF, NPC, and otherrelevant agencies.

Focal Officer responsible for day-to-day

supervision, coordination and overseeing

the implementation of the TA activities

Project Facilitators

Consultants Prof. Tarun Das, Ph.D., Team Leader andMacroeconomic Modeling Specialist.

Prof. Durga Lal Shrestha, Ph.D.,Macroeconomic Modeling Specialist,

Dr. Vikas Raj Satyal, Econometrician

Mr. Rojan Bajracharya, IT Specialist

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Acknowledgements

This Inception Report summarizes the basic objectives and scope of the project and themajor duties, responsibilities, Terms of Reference (TOR) and detailed work plan of theConsultants viz. the International Macroeconomic Modeling Specialist Dr. Tarun Das,

National Macroeconomic Modeling Specialist Dr. Durga Lal Shrestha, NationalEconometrician Dr. Vikash Raj Satyal and National Information Technology (IT)Specialist Mr. Rojan Bajracharya.

The Report has been produced on the basis of consultations and discussions with theprincipal stakeholders and the information and advice provided by them. I express mysincere gratitude to everyone (a List of officers met is given in Annex-8) who has giventheir valuable time for discussions.

First of all, I am grateful to Mr. Shahid Parwez, Program/ Project ImplementationOfficer, ADB Nepal Resident Mission for providing all possible support, guidance,

briefing and encouragements at every stage of my works and even before my joining theProject at Kathmandu.I would like to thank Mr. Trilochan Pangeni, the then Executive Director, ResearchDepartment for proving valuable backgrounds of the modeling works at the NRB. Iwould also like to thank Mr. Ravindra Prasad Pandey, the present Executive Director,Research Department and the Chairman of the Technical Committee for setting themotion for modeling works under the project.

I would like to express my sincere gratitude and thanks to Dr. Nephil Matangi Maskay,Director (Research), Nepal Rastra Bank for overall guidance and valuable discussionsand comments on an earlier draft. I would like to express my thanks to Dr. Bama DevSigdel, Deputy Director and Dr. Ram Sharan Kharel, Assistant Director, ResearchDepartment, NRB, for their enthusiastic cooperation, keen interest, useful discussions andfor providing relevant data and documents.

Finally, I would like to thank my colleagues- the national consultants Prof. Durga LalShrestha, Macroeconomic Modeling Specialist; Dr. Vikash Raj Satyal, Econometricianand Mr. Rojan Bajracharya, Information Technology (IT) Specialist for providing vitalinputs for preparation of this report.

It is needless to mention that the report expresses my personal views and I am solelyresponsible for any errors and omissions.

Kathmandu. Nepal Tarun Das

8th October 2009. Team Leader

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Source: Nepal at a Glance, by the World Bank, dated the 24th Sept 2008.

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INCEPTION REPORT:

NEPAL MACROECONOMIC MODEL (NMEM) AND

DYNAMIC STOCHASTIC GENERALEQUILIBRIUM (DSGE) MODEL-

MODEL STRUCTURES, DATA BASE, AND SOFTWARE-HARDWARE REQUIREMENTS

DR. TARUN DAS

INASSOCIATIONWITH

PROFESSOR DURGA LAL SHRESTHA

DR. VIKASH RAJ SATYAL

MR. ROJAN BAJRACHARYA

1. Introduction- Scope, Background and Outline

Would you tell me please, which way I ought to go from here? asked Alice.That depends a great deal on where you want to get to. said the cat.

I dont much care where . said Alice.

Then it does not matter which way you go. said the cat.

--- Extract from Alice in Wonderland, Lewis B. Carrol

Eventually Alice in Wonderland realized that it does matter a great deal to know whereto go and how to get there. Similarly, in budgeting, planning and monetaryprogramming, it is important to know the vision, mission and basic goals of an agency;the scope of its activities in terms of exact inputs, outputs and outcomes in the mediumterm, and how to achieve these activities with least resources. Modeling and projectionshelp to have a clear vision by the planners and facilitate preparation of sound strategicbusiness and financial plans by a budgetary or monetary agency.

1.1 Characteristics of an Ideal Macroeconomic Model

Desirable characteristics and scope of an ideal macroeconomic model, factors affectingits formulation, test and calibration; types of various macroeconomic models and theirrelative merits and demerits are discussed in details in Annex-3. A model (like a modelfor a house or automobile) is an approximation of reality and contains basic features, andnot the exact features of the real object. A macroeconomic model consists of a set ofmathematical, statistical and econometric equations indicating best possible inter-relationships among major macroeconomic variables. The size and basic building blocks

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of any macroeconomic model depend on various factors such as underlying objectives,choice of planning horizon, sectoral disagregation and regional disagregation, availabledata base, socio-political-global economic context and available resources in terms ofskilled manpower, money and the information and communications technology (ICT).There are various types of macroeconomic Models (for details see Annex-3) such as

static or dynamic, consistent or optimizing, partial or general equilibrium, sectoral oreconomy wide, spatial or regional, inter-temporalorintergenerational, closed or open.

An ideal model should preferably be less complex but comprehensive and dynamic,internally consistent with unique and stable solutions, and should be easily specified,identified, estimated, tested and calibrated with the help of reliable data, computercapacities, simple algorithms and simple statistical/ econometric techniques. A Modelshould be continually tested, calibrated, monitored, reviewed, updated, simulated andimproved to make it more realistic over time.

1.2 Background of the Project

The task of the International Macroeconomic Modeling Specialist is to deal with theComponent-B of a wider project called Nepal: Strengthening Capacity forMacroeconomic Analysis - TA-7165 (NEP), which is being funded by the AsianDevelopment Bank (ADB). The TA will enhance the Governments capacity foreconomic policy formulation based on reliable macroeconomic data and sound policyanalysis. The TA has two distinct parts viz. (a) to further improve the national statisticalsystem and (b) to develop and use macroeconomic models for policy simulations,forecasting and economic planning. While component-A of the TA deals with part (a)and is being executed by the Central Bureau of Statistics (CBS), Component-B deals withpart (b) and is being executed by the Nepal Rastra Bank (NRB).

Modeling Team comprises Prof. Tarun Das, Macroeconomic Modeling Specialist/ TeamLeader; Prof Durga Lal Shrestha, Macroeconomic Modeling Specialist; Dr. Vikas LalSatyal, Econometrician and Mr. Rojan Bajracharya, IT Specialist. The basic task of theModeling Group is to review and upgrade the Nepal Macroeconomic Model (NMEM)built by ADB in 2005 and to build an alternative Model in the framework of a DynamicStochastic General Equilibrium (DSGE) Model. The respective Terms of References(TOR) of the consultants are reproduced in Annex-5, the respective brief CVs of theconsultants are given in Annex-6.1 to Annes-6.4 and the respective Work Plan Matricesare given in Annex-7.1 to Annes-7.4.

1.3 Meeting with Project Implementation Officer

Prof. Tarun Das arrived Kathmandu on Sunday, the 23rd August 2009 and reported to Mr.Shahid Parwez, Program/ Project Implementation Officer, ADB Mission Resident Officeat Srikunj, Kamaladi, Kathmandu on the morning of Monday, the 24 th August 2009. Mr.Parwez briefed on the overall scope and basic objectives of the project, and explaineddetailed Terms of Reference (TOR). Mr. Parwez emphasized that the job of anInternational Macroeconomic Modeling Specialist envisaged under the TOR is very

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challenging as he is expected to have high technical capability to deal with complexeconometric models, provide advice on selection of desired software and hardware,prepare manuals on test, calibration, algorithms and projections; and provide hands-ontraining to the officers engaged in modeling. He further advised that an Inception Reportis required to be produced within one month followed by quarterly and half yearly

progress reports on the modeling works. All tasks under the Terms of Reference have tobe delivered in a time-bound manner as and when required by the authorities.

Mr. Das assured Mr. Parwez that he fully understands the challenging tasks andresponsibilities of the International Macroeconomic Modeling Specialist and wouldprovide his best efforts and knowledge to come up to the expectations of the authorities.However, he expects full cooperation of other members of the Modeling Group and allpossible help by the Executing Agency to provide required infrastructure support, andrelevant data and information in time.

1.4 Meeting with Nepal Rastra Bank

In the afternoon of Monday, the 24 th August 2009, Mr. Parwez organized a meeting withDr. Nephil Matangi Maskay, Director (Research), Nepal Rastra Bank, where localconsultants and the modeling facilitators Dr. Bama Dev Sigdel, Deputy Director and Dr.Ram Sharan Kharel, Assistant Director, Research Department, NRB, were also present.Details of the works plan and the role of the NRB as the EA were discussed. The NRBwas requested to set up a Technical Committee and to develop contacts with the SteeringCommittee as early as possible. In consultation with Dr. Maskay, the Team Leader hasprepared a Work Plan which is reproduced in Annex-7.1.

Next day (Tuesday the 25th August, 2009) International Consultant had an opportunity tomeet the then Executive Director Mr. Trilochan Pangeni who provided valuable insightson the modeling works at the NRB. Subsequently, on Wednesday, 2nd September 2009the International Consultant met the present Executive Director Mr. Ravindra PrasadPandey, who is also the Chairman of the Technical Committee.

1.5 Implementation and Institutional Arrangements

CBS is the Executing Agency (EA) for component A of the TA and NRB for componentB. Both components of the TA will be implemented in close coordination with otherrelevant Government agencies, including MOF, NPC, and other line ministries anddepartments. Until a Focal Officer is decided by the Technical Committee, Dr. NephilMatangi Maskay, Director (Research Department), Nepal Rastra Bank, has been kindenough to take the responsibility for overall supervision and coordination, and to overseethe day-to-day implementation of the TA activities on modeling, to maintain closecoordination with all relevant stakeholders, and to manage the consultants inputs.

For both the components, a Steering Committee will be formedchaired by the relevantNPC Member and comprising representatives of MOF, NRB, CBS, and other relevantline ministriesto provide overall policy guidance for implementation of the TA,

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monitor progress, and take necessary actions to facilitate implementation of the TA. Inaddition, two Technical Committees (TCs) will be formed to provide technical adviceand guidance on the respective TA activities. For component-B on Modeling works, TCwill be chaired by the Executive Director (Research), NRB and comprise representativesof MOF, NPC, and other agencies. The technical committee will also coordinate with

other macroeconomic modeling activities; including the proposed UNDP supportedmacroeconomic modeling for monitoring the MDGs.

1.6 An Outline of the Report

With this brief introduction on modeling and project background, the rest of the reporthas 9 additional sections and 9 Annexes.Section-2 deals with both global and domesticeconomic context of modeling. Section-3 makes a critical appraisal of thecurrent state ofthe Nepalese economy, its development challenges, problems and prospects, and itsinherent strengths, weakness, opportunities and threats (SWOT analysis). Section-4makes a critical review of the macroeconomic modeling works for Nepal. Section-5

describes alternative macroeconomic models and building blocks for an operationalmacroeconomic model for Nepal. Section-6 describes an analytical framework of ageneral equilibrium model for Nepal. Section-7deals with specific work plans and briefdescriptions of the activities of the consultants during the project period.

Section-8 makes a critical review of the Nepal Macroeconomic Model (NMEM)developed by the ADB in 2005 and provides the upgraded structure of the NMEM, whichwill be calibrated and tested by the consultants. Section-9 provides a tentative structurefor an operational Dynamic Stochastic General Equilibrium (DSGE) Model for Nepal,which will be fully developed, tested and calibrated by the consultants with available dataand computer algorithms. Section-10 recommends hardware and software requirementsfor estimation, test, calibration, projection and simulations of the models.

The report is then followed by selected references and nine Annexes. Annex-1 andAnnex-2 present trends of major macroeconomic variables and poverty and other socialindicators for Nepal. Annex-3 makes a critical review of basic characteristics, types andtechnical structures of various macroeconomic models. Annex-4 provides the completelist of variables and data requirements for the specification, test and calibration of theupgraded Macroeconomic Model and the Dynamic Stochastic General Equilibrium typeof model for Nepal.Annex-5 reproduces the respective Terms of Reference (TOR) of theconsultants as specified under the ADB Project (TA-7165-NEP) on Nepal: StrengtheningCapacity for Macroeconomic Analysis. Annex-6 provides brief curriculum vitae of theconsultants, while Annex-7 provides the respective Work Plan Matrices of theConsultants.

Annex-8 presents the broad features, licensing conditions or commercial and governmentvolume contracts for the E-Views 6 Software which is recommended by the modelingteam for estimation, test, calibration, forecasting and simulation the Nepalmacroeconomic models. Annex-9 provides a list of officers who were consulted toprepare this report.

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2. Economic Context of Modeling

Before reviewing modeling structures, it may be useful to provide a brief account of theglobal economic situation and the current state of the Nepalese economy.

2.1 Global Financial-Food-Fuel Crisis and Economic Slowdown

It is well known that the global economy is presently passing through a criticalconjecture. It was adversely affected by three worst crises in fuel, food and financialsectors (called F-3 Crisis) in a single year in 2008 - the first massive F-3 crisis in the last70 years since the great depression in 1930s. Both the advanced and developing countrieshave adopted various monetary and fiscal stimulus packages (such as cuts in central bankpolicy interest rates, continued provision of bank liquidity, credit easing, provision of

public guarantees, bail outs and bank recapitalization etc.)to boost both investment andconsumption, output and employment. In their latest World Economic Outlook (WEO)6

of October 2009, the International Monetary Fund (IMF) concludes that although the

global economy has started to pull out of the unprecedented recession, recovery isexpected to be weak and slow, and jobless for sometime, as financial systems remainimpaired, support from public policies will gradually have to be withdrawn, and

households that suffered asset price busts will continue to rebuild savings.

As per the IMF projections made in the WEO October 2009, global growth is expectedto reach about 3 percent in 2010, following a contraction in activity of about 1 percent in2009 (Table 2.1). During 201014, global growth is expected to be just above 4 percent,appreciably less than the 5 percent growth rates in the years just ahead of the crisis.Achieving this turnaround will depend on stepping up efforts by the governments of bothdeveloped and developing countries to heal the financial sector, while continuing tosupport demand with monetary and fiscal easing.

In recent years Asian economies in general experienced an economic boom contributedby two favorable factors: namely (a) rising exports driven by high commodity prices,and (b) increasing inflows of remittances and foreign investment. The ongoing financialcrisis and economic slowdown in the developed countries have led to reversal of thesepositive factors and imposed serious adverse impact on the Asian economies.

Growth projections in emerging Asia have been revised upward to 6.2 percent in 2009

and 7.3 percent in 2010. The upgrade owes to improved prospects in China and India, in part reflecting substantial macroeconomic stimulus; and a faster-than-expectedturnaround in capital flows. However, the recent acceleration in growth is likely to peterout unless there is a recovery in advanced economies.

Growth is expected to moderate particularly in commodity exporting countries, andmany countries are experiencing declining exports and lower inflows of tourism income,remittances, and foreign direct investment (FDI), while aid flows are under threat.

6World Economic Outlook- Sustaining the Recovery, October 2009, IMF Washington D.C.

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Table-2.1 IMF WEO (Oct 2009) Projections (Annual Growth Rate in Percentage)

Source: World Economic Outlook- Sustaining the recovery, October 2009, International Monetary

Fund, Washington D.C.

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2.2 Impact of Global Economic Crisis on Nepals Economic Growth

A crisis of this magnitude in the industrialized countries is bound to have an adverseimpact around the world. Nepalese economy may not be an exception to it. Nepal is alow-income and land-locked country. With an area of 147,181 km (98 th in the world) and

population of 29.5 million (41st

as per 2007 UN estimate), Nepal had a per capita incomeof only US$291 (195th among 207 countries) in 2007 and low domestic purchasing power. So its growth depends on external demand and growth in the neighboringcountries and other trading partners. Nepal has always maintained a relatively openeconomy for trade and investment, although exchange rate is pegged to Indian rupee.

As is evidenced by table 2.2, exports of goods and services and external transfers(particularly grants and workers remittances) have significant contributions to GDP. Thetable further indicates that the external flows were not adversely affected by the globalfinancial crisis and the economic slowdown.

Nepals total trade (exports plus imports) of goods and services as percentage of GDPincreased from 45 percent in 2007 to 46 percent in 2008 and further to 48 percent in2009. Gross flows on current account (i.e. total inflows plus outflows on goods, services,income and transfers) as percentage of GDP increased from 66 percent in 2007 to 71percent in 2008 and further to 78 percent in 2009. Similarly, gross flows (inflows plusoutflows) on both current, and capital and financial account as percentage of GDPincreased from 70 percent in 2007 to 76 percent in 2008 and 85 percent in 2009.

The Nepalese economy was least affected by the initial adverse effects of global financialcrisis. The reasons include the following:

(a) Nepals financial sector has limited external liabilities and assets.(b) Although its external current account has close links with the rest of the world,

the major link is with India which maintained relatively high growth rates duringthe crisis period.

(c) Nepal and India also maintained normal trade links.

Table-2.2: Nepal: Measures of globalization

(As % of GDP at current market prices)

Items 2007 2008 2009

1. Exports of goods & services 13 13 13

2. Imports of goods & services 32 33 36

3. Gross Trade (Exports plus imports)=1+2 45 46 48

4. Gross Income (Inflows + outflows) 3 2 2

5. Gross transfer (Inflows + outflows) 19 23 28

6. Gross Current Account = 3 + 4 + 5 66 71 78

7. Gross Capital and financial flows 3 5 7

8. Gross current + Capital flows = 6 + 7 70 76 85

Source: Estimated on the basis of primary data obtained from the Nepal Rastra Bank.

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Economic Growth

(a) Although the initial global financial crisis did not have much adverse impact onthe Nepals financial sector, the real sector growth in 2008/09 has been affectedadversely due to domestic factors such as unfavorable monsoon and labor unrest.

Based on the data available for the first six months of the fiscal year 2009, the CentralBureau of Statistics (CBS) has estimated the real GDP growth rate at basic prices isexpected to decelerate from 5.3% in FY2008 to 3.8% in FY2009. The slowdown isexpected to be broad-based, encompassing agriculture, industry and services. Theagriculture sector is expected to grow by only 2.2% in FY2009, down from 4.7% inFY2008; industrial sector by 1.8% almost the same as 1.9% in FY2008; and servicesector by 5.8%, significantly down from 7.0% in FY2008.

(b) There is acceleration of the consumer price inflation which is presently runningaround 13 percent due to high food prices. The stock market is bearish in general.However, the fiscal situation and the balance of payments have surplus on current

accounts and macroeconomic fundamentals are sound. Both the government and themonetary authority deserve to be complemented for maintaining economic stability ina difficult socio-economic-political context.

3. Recent Economic Development in Nepal

3.1 Tenth Plan Period

In recent years Nepal made significant progress toward sustainable economic growth andis committed to the so-called LPG (viz. liberalization, privatization and globalization).Government priorities over the years focused on the integrated development ofagriculture, industry, transportation and communications. Agriculture remains Nepal'sprincipal economic activity, employing 70% of the wok force and contributing 33% toGDP. Rice and wheat are the main food crops. Out of total land, only 20% is cultivable;another 33% is forested; and the rest is mountainous.

The performance of the Tenth Plan was mixed. Significant progress was made in theareas of MDG indicators including poverty reduction, but the achievement on economicgrowth was below expectations.

The Tenth Plan had targeted normal economic growth rate to be an annual 4.3 percent onan average (agricultural sector 2.8 and nonagricultural sector 5.2). However, during thePlan period the average annual growth rate remained 3.4 percent (agriculture sector 2.67 percent and the non-agriculture sector 3.79 percent). Some structural changes in theeconomy were observed. Over the period, the contribution of agricultural sector in GDPdeclined from 37.4 percent to 33.1 percent, while that of non-agricultural sector increasedfrom 62.6 percent to 66.9 percent. Among the non-agriculture sector, trade andcommerce, hotel and restaurant performed better,

During the plan period, the total consumption, on an average, remained 89.84 percent.The gross capital formation remained 25.57 percent of the Gross Domestic Product.

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Similarly, the Gross Domestic Savings remained an annual average of 10 percent andGross National Saving 28.1 percent of the Gross Domestic Product. Although no changewas seen during the Tenth Plan period in the Domestic Saving and Consumption, apositive change in Gross Capital Formation and Gross National Savings was observed.During the plan period there was some deterioration in the current account surplus, whereasan improvement has been observed in the balance of payments position

Despite sound macroeconomic management by the government, foreign investors stayedaway from Nepal due to political uncertainty and difficult business environment. Fiscalmanagement, in general, was under control. Revenue increase, together with a decliningtrend of development expenditures in real terms helped to keep fiscal deficit withinsustainable limits. However, resource gap, measured by the saving-investmentdifferences, increased from 11% of GDP in 2002 to 18% of GDP in 2006. On thecontrary, Gross National Savings (GNS) increased significantly mainly because ofincreasing remittances inflows.

The average annual inflation measured by the national consumer price index, was

contained at the average rate 5.5% during the Tenth Plan with a peak of 8% reached in2005/06 mainly because of rise in petroleum product prices. Transport, communicationsand housing recorded the highest price rises during the Plan period.

During the Tenth Plan, despite deceleration of the exports growth and rising trade deficit,the current account and overall balance of payments position remained strong due toincreasing inflows of remittances.

3.2 Three Year Interim Plan (2007/08 to 2009/2010)

As the Tenth Plan came to an end in July 2007, after the culmination of a series of

historical struggles in the form of the 2006 People's Movement, the National PlanningCommission (NPC) prepared a three year Interim Plan from FY 2007/08, consistent withthe peoples aspirations, the Interim Constitution, and the Common Minimum Program ofthe government. For the first time in the country's history of plan formulation, the NPCtargeted to more than 70 VDCs of 30 districts, carrying out direct observation andcollecting people's suggestions. Similarly, at the central level, consultations were heldwith all stakeholders.

The main objective of the Interim Plan is to realize changes in the life of people byreducing poverty and unemployment and establishing sustainable peace. It puts specialemphasis on increasing public expenditure for employment generation, peace building,

reconstruction, rehabilitation, reintegration, inclusion, and revitalization of the economy.Similarly, the Plan provides special attention to women, the poor, weaker sections of thesociety and development of remote areas.

The strategies of the Plan include the following:

To give special emphasis to relief, reconstruction and reintegration:

Creation and expansion of employment opportunities.

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To increase pro-poor and broad-based economic growth,

Promotion of good-governance and effective service delivery:

Increase investment in physical infrastructures:

Adopt an inclusive development process.

Clear policies, institutional structures and programs, and

Carry out targeted programs.

The following table summarizes the quantitative targets of the three year Interim Plan.

3.3 Social Development Indicators and MDGs

Despite politically difficult situation, trends of many poverty and socio-economicindicators in the 10th Plan period were encouraging (Annex-2). The incidence of povertyfell from 42% in 1996 to 31% in 2004. Similarly, the Demographic Health Survey (2007)shows that net enrollment in primary school rose from 80.4% in the beginning of the Planto 87.4% in 2007. Maternal mortality rate, child mortality rate and infant mortality ratedeclined, significantly during the Plan period.

However, a joint study by the National Planning Commission of Nepal and the UNDPCountry Team in Nepal indicates that Nepal remains off-track as regards the MDGtargets on universal primary education and incidence of HIV/ AIDS, malaria and otherdiseases (NPC/ UNDP 2005).

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3.4 External Debt Situation

As the country's investment requirements far exceed the internal savings, access toexternal capital, in the form of loans or grants, is inevitable. However, Nepal hasmanaged external debt very well. The external debt to GNI declined from 52 per cent in

FY2000 to 38 per cent in FY2006, and external debt service (to exports of goods andservices ratio) declined from 9.7 per cent to 5.1 per cent over the same period. Nepal'sexternal debt stock is composed of high levels of concessional loans with long maturitiesand nominal interest charges. The share of short-term debt in total debt is negligible,although in recent years it has shown an upward trend. The country has foreign exchangereserves, equivalent to about 7.5 months imports cover.

Table-3.1 External Debt Situation in Nepal (US$ Million)

Items 2000 2001 2002 2003 2004 2005 2006

Ext.Debt outstanding 2869 2735 2992 3164 3358 3198 3409

Long-term Debt 2827 2673 2948 3139 3300 3130 3285

Short-term Debt 29 54 40 13 36 47 81Use of IMF credit 12 8 4 11 22 20 43

Sustainability Indicators

Ext.Debt as % of GNI 52 45 50 50 46 39 38

Short term/ Total Debt (%) 1.0 2.0 1.3 0.4 1.1 1.5 2.4

Debt service/ XGS ratio (%) 9.7 7.0 6.3 6.1 5.6 4.7 5.1

Interest (percent per annum) 1.4 1.3 1.2 1.0 1.0 1.1 1.3

Maturity (years) 31.4 30.5 33.7 34.9 36.8 34.6 24.6

Grace period (years) 8.1 8.2 9.8 9.3 9.5 8.7 8.1

Grant element (percent) 69.5 69.5 73.3 75.1 76.8 74 66Note: Years refer to fiscal year.

3.5 Economic Outlook, Problems and Prospects

The Central Bureau of Statistics (CBS) of Nepal has estimated that the Real GrossDomestic Product (GDP) would grow by 3.8% in 2008-2009, compared to 5.3 percentrecorded in 2007-2008. However, as per the assessment made by the ADB7, the growthrate is likely to be lower due to poor winter crop, deceleration in remittances inflow andslower industrial growth caused by continued power shortage and long-term structuralweaknesses in the economy. The deceleration of the growth rate is also partly due to theglobal economic slowdown as discussed earlier.

Overall annual point-to-point consumer price inflation at the end of ten months of 2008-2009 stood at 12.9% driven by high food prices and higher salaries and wages. With poorwinter crop output, it is unlikely that inflation will moderate significantly for the rest ofthe year. In general, it was observed in the past that there exists a high positivecorrelation between inflation rates in India and Nepal. However, in the recent months,Nepalese inflation has not followed the decelerating trends of the Indian overall inflation,due to high food prices in both India and Nepal.

7 Quarterly Economic Update- Nepal, Vol.VI, No.1, June 2009, ADB.

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Money supply is expanding at a lower rate than last year, and the momentum in liquidityexpansion has been curtailed by large share subscriptions of commercial banks. But,given a fixed exchange rate with Indian Rupee since 1991 and high international prices ofmajor imports of Nepal (viz. food items and petroleum products), Nepal Rastra Bank

(NRB) has a difficult task of controlling inflation without impeding much-neededinvestment for sustaining economic growth.

Tax reforms introduced in the past have led to an improvement in revenue mobilizationand a healthy fiscal position, although it is partly due to low capital spending.

In the external sector, both the current account and the overall balance-of-paymentpositions remain in surplus, although inflows of foreign investment have been adverselyaffected to some extent by political environment. Within the current account, trade deficitcontinues to widen, but it is more than offset by remittances inflow and tourism receipts.It is expected that external balance will remain favorable due to continued inflows of

remittances by Nepalese citizens working abroad.

Nepals commercial banks hold insignificant foreign liabilities. Consequently, the first-round effects of the global downturn were not observed in Nepal, although the Nepaleserupee depreciated against third currencies due to its peg to the Indian rupee. The outlookof other channels such as trade and remittances is also optimistic, although tourist arrivalshave declined in recent months.

3.6 Development Challenges and Issues

During the last five years the Nepalese economy had performed reasonably well withmoderate and stable economic growth, increasing per capita income, buoyant investment,moderate inflation, low fiscal deficit and favorable balance of payments situation. But,these favorable trends have not led to commensurate reduction of poverty in rural andhilly areas. This implies that the so-called trickle down effects of growth had beendelayed, slow and uneven. The worldwide recent financial crisis and economic slowdownalong with domestic political transition might have further exacerbated the economicsituation in Nepal.

These trends have led to various development challenges such as how to sustaineconomic growth with fiscal prudence, monetary discipline and price stability, how topromote equitable growth and to raise the levels of living of all citizens, how to eradicatepoverty, hunger and disease and to attain other Millennium Development Goals (MDGs)at a faster speed, and how to create enabling environment for public-private partnershipand international cooperation in the development process for improving quality anddelivery of basic public goods and services.

Another important development challenge is how to use government revenues forattaining higher growth and at the same time tackling the problems of poverty andinequity. Although the concerned ministries have the major responsibilities for achieving

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MDG targets, the Ministry of Finance and the National Planning Commission, being thecoordinating Agencies, have special responsibilities to provide necessary advice anddirections to other ministries.

The core challenge for the government budget is how to adopt long-term MDG targets

within the annual and medium-term national budget constraints and priorities. MDGstrategies are both needs basedand resource constrained. The national budget musttake care of poverty reduction strategies as a guide to MDG action, and set out clearpriorities for pro-poor public expenditure and investment plans based on a realisticassessment of the available resources and the needs of other sectors.

The countrys economic growth has remained low and needs to be reinvigorated byincreasing agriculture production and productivity and improving environment for privateinvestments including foreign investment. There is also need to improve institutional setup and governance, liberalize labor laws, and improve investment climate and physicalinfrastructure. Nepals road density is one of the lowest even among the least developed

countries. Similarly the country suffers from severe electricity shortage.

Population pressure on natural resources is increasing. Over-population is alreadystraining the "carrying capacity" of the middle hill areas, particularly the KathmanduValley, resulting in the depletion of forest cover for crops, fuel, and fodder andcontributing to erosion and flooding and other environmental hazards.

The challenge is not only of accelerating growth, but also of sharing the growth and prosperity more broadly across the population. Building social and human capital,creating employment opportunities and implementing affirmative actions to the excludedgroups are probably the best ways for reducing poverty and inequality in the country. Ifall Nepalese people are healthy, educated, skilled and live longer, they can participatefully, contribute more and gain from the development process..

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3.7 SWOT Analysis for the Nepalese Economy

On the basis of above discussion, a SWOT analysis of the Nepalese economy is presentedin the following table.

Table-3.2 SWOT Analysis of the Nepalese Macro-economy

Internalenv

ironment

Strengths

1. Sustainable moderate economic growth in recent years2. Good performance by services sectors.3. Rising trend of tax/ GDP ratio;4. Manageable fiscal deficit, with surplus in overall fiscal balance

in 2008/09.5. Rising trend of gross domestic investment ratio6. Rising trend of national savings ratio7. Good performance of major social development indicators

including reduction of poverty8. Country is on track on most of the MDG targets

Weaknesses

1. Growth rate remains vulnerable to weather shocks;2. Low productivity of agriculture;3. Industrial sector remains week due to political uncertainty,

labor unrest, and constraints on electricity supply and otherinfrastructure facilities;

4. Inflation pressures in 20095. Low levels of domestic savings6. Large proportion of current expenditure and low levels of

investment in public expenditure7. Although overall poverty ratio is declining, poverty incidence

remains high in rural and hilly areas8. Degradation of environment in cities

Externalenvironment

Opportunities 1. Located between two giant economies and fast growingneighbors (China and India) with positive pulls and pushes onthe Nepalese economy

2. Surplus in the external current account during 2004-2009except for marginal deficit in 2007

3. Comfortable foreign exchange reserves (equivalent to 7.5months of imports during 2006-2009)

4. Declining ratios of external debt to GDP ratio5. Very low external debt service ratios indicating sustainability

of external debt over time (and possibility of no debt trap)

Threats Overall economic growth and government revenue remainvulnerable to terms of trade shocks trigged by possible sharp

declines in international prices of Nepalese exports Deceleration of remittances growth in 2009

Balance of payments remains vulnerable to future risk ofhardening of global oil prices

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4. Building up an Operational Macroeconomic Model for Nepal

A comprehensive Macroeconomic Model can specify, test and calibrate complex anddynamic interrelationships among major economic variables with the help of powerfulanalytical, statistical and econometric tools that can be very useful for forecasting and

policy planning by the Ministry of Finance, National Planning Commission, Nepal RastraBank and other departments and stakeholders both within and outside the government.

A macroeconomic model can analyze trends of both the internal and external variables ina consistent analytical framework, and address various important issues such ascontrolling inflation, tackling balance of payments problems, sustaining growth in themedium to long term, examining inflation-growth-poverty-inequality trade-offs,managing public debt and fiscal deficit at sustainable levels, and determining permissiblelevels of monetized fiscal deficit. As observed by Clements and Hendry (1995): Formaleconometric systems of national economies fulfill many useful roles others than justbeing devices for generating forecasts. For example, such models consolidate existing

empirical and theoretical knowledge of how economies function, provide a frameworkfor a progressive research strategy, and help explain their own failures.

4.1 Basic Purpose and Dimensions of a Macroeconomic Model

The basic purpose of the model is to make the projections of the following variables forthe medium term 2009/10-2013/14:

Sectoral GDP and overall GDP Distribution of GDP among private and government consumptions, savings,

investment, exports and imports

Consumer price and overall price inflation, interest and exchange rates, Government fiscal operations, overall fiscal balance and public debt, Major items in the balance of payments, and

Major monetary and financial statistics.

Existing economic system is complex and has close linkages with the socio-political-external environment. Naturally a modeller needs to make certain presumptions aboutthese initial conditions and to build alternative scenario for future. So, a number ofquestions need to be answered before an operational model can be developed:

How can we understand such a complex system?

Are our preconceptions correct?

Do we have a reliable data base for the past 25 years?

Do the available data tell us what we desire to know?

How complicated or simple the Models should be? Can the alternative Scenarios built by modellers address the questions raised by

policy makers and other stakeholders?

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These questions are simple, but there are no simple and general answers. A modeller hasto make a compromise between what is theoretically and technically justified and whatkinds of data are produced by the CBS, NPC, MOF, NRB and other agencies.

Preconceptions: Economic development is a historical process which depends on:

Existing socio-political-legal-institutional context Financial, capital and money markets Labour markets, labour laws and industrial technology State of infrastructure, information and communications technology (ICT) Public policies and available resources

Global economic environment and prospects

Can we capture the historical process with past trends of statistical data? The answer is-yes and no. If the past statistical data are incomplete and imperfect, future cannot bepredicted on the basis of it. Fortunately, for modellers, over the years Nepal has built upauthentic and comprehensive data bank on all sectors of the economy and these are easily

available on the websites of the MOF (www.mof.gov.np/), CBS (www.cbs.gov.np/) andthe NRB (www.nrb.org.np/ ).

The best set of data available for the Nepalese economy includes the following:

Government Financial Statistics produced by the MOF National accounts, real sectors and prices statistics produced by the CBS

Balance of payments and exchange rate data produced by the NRB Monetary and Financial Statistics produced by the NRB

A modeller also faces the following questions while specifying models.

How much detailed a model should be? What are the structural relationships and the reduced form relations? Are these relevant to the questions we want to answer? Are these consistent with what we know about institutions? Are these consistent with results of past studies? Are these dynamic enough to capture in changes in food and oil prices?

How much regularity and time gap should be there for updating a model?

4.2 Alternative Macroeconomic Models

Depending on the purpose and availability of data and resources, alternative

macroeconomic models as indicated below can be explored:

(i) Consistency Model in the Leontief Input-Output (I-O) Framework(ii) Social Accounting Matrix (SAM) and General Equilibrium Model(iii) Linear Programming (LP) Model and Gravity Model(iv) Structural Macroeconometric Model(v) Vector Autoregressive (VAR) Model(vi) Dynamic Stochastic General Equilibrium (DSGE) Model

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http://www.mof.gov.np/http://www.cbs.gov.np/http://www.nrb.org.np/http://www.mof.gov.np/http://www.cbs.gov.np/http://www.nrb.org.np/


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Brief descriptions of these models with their relative merits and demerits are presented inAnnex-3. It may be observed from the discussions that there does not exist a universalmodel which holds good at all times and for all countries. There is also no generalagreement among the modelers regarding the choice of a particular model for a country.

Modelers welcome that Let all the flowers bloom and flourish.

Macroeconomic Modeling Specialist and other consultants did not have enough time toreview in details the existing data base in Nepal and the level of capacity in terms of bothskilled human resources and the information and communications technology (ICT) inthe government departments and in the Nepal Rastra Bank. Therefore, it is difficult at thisstage to indicate the types of models which will be most suitable for Nepal.

4.3 International Best Practices and Lessons for Macroeconomic Modeling

International best practices and the authors own experiences in modeling in selected

developing countries in Asia and Africa (such as India, Cambodia, Mongolia,Philippines, and the Gambia) lead to the following conclusions:

(a)A limited purpose model is better than a general purpose model.(b)A positive (operational) model is better than anormative (theoretical) model.(c)Apolicy oriented model is better than a general forecasting model.(d)A short run/ medium term model is better than a long run model.(e)A model with selected sectors is better than a large economy-wide model.(f) A partial equilibrium model is better than a general equilibrium model.(g)A behaviorist model is better than a Linear Programming optimizing Model.(h)An econometric model is better than a Leontief Input Output Model.(i) Models should be selected to address specific problems and objectives.

(j) It is better to depend on expert guess on the crucial variables (such aspopulation, weather, international food and oil prices, domestic technology,minerals exploration etc.), which have major impact on productivity and growthrather than completely leaving out missing data on these variables.

(k) Computerized models on social systems cannot be expected to produce preciseresults. But these can be used for creating vision and indicative planning.

(l) Quantitative results need to be justified by qualitative judgments which are veryuseful for policy planning.

(m) Social- political contextmay be treated as given in a model.(n)Models should be tested rigorously and simulated for the real world with full

range of policy options.

(o)Modelers should specify sources of data and share basic data with others.

(p)Substantial portion of resources should be used for full documentation of themodel, so that any other group can test, calibrate and run the model.

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5. A brief review of the past economic modeling exercises in Nepal

Since 1980s, individual researchers had attempted to use statistical techniques andeconometric models for economic analysis and forecasting in Nepal.

1) In 1985, a multi-sector, economy-wide model was first introduced by Khanal,Thapa and Elbers (1987)8.

2) In 1987, the Water and Energy Commission developed a macro model forforecasting energy demand.

3) In 1989, a macro-economic model in the Leontief input-output frameworkcomprising 39 sectors was also developed to prepare long-term industrial plansand to formulate alternative development strategies for the economy9. The basicobjective of the model was to determine the optimum volume of investment underan acceptable rate of inflation, acceptable fiscal deficit, realistic level of foreign

assistance, and a stipulated growth rate for per capita consumption.

4) A similar version of the macroeconomic model was also used in the formulationof the Eighth Plan.

5) In 1992 another macro model was developed as a part of the link model for theSouth Asian Association for Regional Cooperation (SAARC) countries10 toexamine the impact of regional trade on its member economies.

6) A slightly different model in the framework of the standard flow-of-fundsaccounting, commonly used by the World Bank and the International MonetaryFund, was developed for the National Planning Commission Secretariat Project.In the model, different building blocks viz. the national accounts; the budget andpubic sector account; the balance of payments (BOP) or the rest of the worldaccount; the monetary sector account; and the private sector account; wasintegrated into a consistent accounting framework.

7) In 1990, a simple macroeconomic accounting framework was employed toexamine the possibility of policy coordination between exchange rate policy andfiscal policy for more effective management of the economy11.

8Khanal, D. R., P. J. Thapa, and C. Elbers. 1987.A Regionally Disaggregated Planning Models for Nepal.Kathmandu: NPC/ESCAP/IDS/ISI.

9Development Study Consultants. 1990.Policy Planning Models for the Nepalese Economy with SpecialReference to the Industrial Sector. Mimeo. Kathmandu: DSC/MOI/UNIDO.

10Khanal, D. R. and G. N. Sharma. 1992. A Macroeconometric Model of Nepal in SAARC Link.Nagvi,S.N.H. and S.A. Samad, eds. New Delhi: Oxford and IBH Publishing Co. Pvt. Ltd.

11Cruikshank, E.D. and R.H. Nord. 1990. The Role of Exchange Rate Policy: The Case of Nepal.Mimeo. Kathmandu.

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8) While the Tenth Plan was being formulated, the integrated macro and input-output model was used to set the growth rates and the investment levels at boththe sectoral and aggregate level without disrupting macroeconomic stability.

9) Special attention should be drawn to two other macroeconomic models: Alamgirand Ra (2001)12 and Sharma (1989). The Alamgir and Ra (2001) model projectsGDP growth by major economic sectors on the basis of growth elasticity derivedfrom historical data and adjusted for structural changes.

10) A common feature of the two models is that GDP is predetermined or stipulatedbefore estimating individual equations. These models implicitly assume that thesupply side determines aggregate output, and they predict each endogenousvariable in a way that is consistent with the given output level.

11) There had recent attempts under technical assistance by ADB to develop a

medium a medium size Macroeconomic Model (MEM). A part of TA forStrengthening Institutional Capacity for Public Debt Management, ADB (Ra andRhee 2005) supported the Government in developing a MEM in 2005 known asNepal Macroeconomic Model (NMEM) on the basis of the standard Keynesianincomeexpenditure approach in which gross domestic product (GDP) isdetermined endogenously.

12) Apart from being used by the Government for debt sustainability analyses, NepalRasta Bank (NRB) has also been using the NMEM for economic forecasting.

13) Subsequently to that Khanal and Kane (2005) had utilized a MEM to analyzereduction of domestic poverty, and

14) Bhattarai (2007) had produced an applied dynamic general equilibrium model forNepal.

15) In recent years Nepal Rastra Bank has engaged itself actively for developing itsown MEM which would be consistent with the vision and mission of the Bank.The model was developed by the Macroeconomic Modeling Unit (MMU) of theNRB (2007), Research Departments Economic Analysis Division as a part of itsmacroeconomic modeling activities.

From the above review it follows that the state of the macroeconomic modeling in Nepalis still at an experimental and learning stage. There are a few examples ofmacroeconomic modeling for the purpose of policy planning and formulation of

12Alamgir, M., and S. Ra. 2001. Nepal: Debt Sustainability and Country Risk Analysis. Manila:ADB.

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economic plan. But these were not done on a sustainable, comprehensive and continualbasis. There was also lack of adequate capacity building in the respective agencies.

Besides, the utility of NMEM has become limited due to major structural changes in theNepals economy, and major revisions of key macroeconomic data (such as National

Accounts, Price Statistics, Government Finance Statistics and the Balance of Paymentsover the years) due to changes in base period and basic concepts. Therefore, the NMEMdeveloped by ADB needs to be reviewed and upgraded. In addition, other econometricmodels such as the Dynamic Stochastic General Equilibrium (DSGE) model need to bedeveloped to examine the relative merits and demerits of both these models.

Considerable efforts are, therefore, required for the development of new modelingtechniques with a focus on the direct and practical policy applications by the NepalRastra Bank, Ministry of Finance and the National Planning Commission (NPC).

The basic purpose of the present technical assistance of the ADB is to remove these

deficiencies in macroeconomic modeling and to strengthen technical capability in theNRB, MOF, NPC and CBS for model building and its use for policy planning.

6. Analytical Framework of a General Macroeconomic Model

6.1 Basic Objectives

The basic purpose is to build an appropriate and stable model, depicting the underlyingstructure of the Nepalese economy, which can be used to forecast major macro economicvariables for both the short-term (one year) and medium term (five years) for preparationof budget and national plan and formulation of monetary and fiscal policies. Theprojections will also form the basis for preparing the macroeconomic and fiscal envelopeby the Nepal Rastra Bank to be provided to the Ministry of Finance for pre-budgetconsultations and requirements.

Here we present a general framework for a macroeconomic model, which is consistentwith the concepts under the UN System of National Accounts (UN-SNA), and the IMFGovernment Finance Statistics (GFS), Balance of Payments (BOP) Statistics and theMonetary-Financial Statistics (MFS). This model produces the baseline scenario of themacro economy disaggregated into the five inter-related accounts as indicated below:

(i) Real Sector and National Accounts(ii) Government Sector (Fiscal Account)(iii) Monetary and Financial Sectors(iv)External Sector(v) Prices, Interest Rates and Exchange Rate and

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6.2 Model Structure and Analytical Framework

The basic structures of these sub-models and their interrelations are depicted in the formof a flow diagram in Box-6.1. The linkages between key aggregates of the nationalaccounts and the balance of payments flows can, by the use of symbols, be summarized

algebraically within a savings/investment framework.

National Accounts System (NAS)

GDPFC = Real GDP at constant FC= GDPAG + GDPIND + GDPSER

GDPAG = Agricultural GDPFCGDPIND = Industrial GDPFCGDPSER = Services GDPFCC = private consumption expenditureG = government consumption expenditure

I = gross domestic investmentS = gross savingX = exports of goods and (non-factor) servicesM = imports of goods and (non-factor) servicesNFY = net factor income from abroadGDP = gross domestic productGNP = gross national productGNDY = gross national disposable income

Balance of Payments (BOP)

CAB = current account balance in the balance of paymentsNCT = net current transfersNKT = net capital transfersNPNNA = net purchases of non-produced, non-financial assetsNFI = net foreign investment or net lending/ net borrowing vis--vis the rest of the worldNKA = net capital and financial account (i.e., all capital and financial transactionsexcluding reserve assets)RT = reserve asset transactions

Government Finance Statistics (GFS)

R= Revenue = T + NTT = Tax revenueNT = Nontax revenueGR= GrantsGEXP = Government expenditure and net lending = G + GKG = government consumption expenditureGK= GCE + NDGCE = Government capital expenditure

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ND = Net lendingGFD = Gross Fiscal Deficit

= (R+GR) - GEXP

Monetary-Financial Statistics (MFS)

MD = Demand for money = NFA+CRG + CRP + OIMS = Supply of money = DD + TD + CNCRG = Credits to the government and public enterprisesCRP = Credits to the private sectorNFA =Net foreign assetsOI = Other itemsDD = Demand depositsTD = Time depositsCN = Currency and notes in circulation

Prices, Interest Rates and Exchange Rates

CPI = Consumer Price IndexWPI = Wholesale Price IndexGDPDF = GDP DeflatorINT = Rate of interestPLR= Prime lending rateFDR= Fixed deposit rateER= Exchange rate of Nepalese Rupee

The Macroeconomic Balance Equations stand as follow:

GDP = C + G + I +XM (1)(XM= balance on goods and services in the balance of payments)GNP = GDP + NFY (2)CAB = X M + NFY+NCT (3)GNDY = C + G + I + CAB (4)GNDY = C + G + S (5)

Equating (4) and (5) we get:S I = CAB i.e. saving-investment gap (resource gap) equals CAB (6)

S I + (NKT NPNNA) = CAB + (NKTNPNNA) = NFI (7)

(NKTNPNNA) = balance on the capital account of the balance of payments

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Box-6.1: Basic Structures of Macroeconomic Sub-models and Inter-linkages

NMEMs

33

National AccountsReal Sector (Supply Side)GDP = GDPi

Where GDPi = GDP of i-th sector

Demand/ Expenditure Side

Private consumption Gen. govt. consumption Gen. govt. investment Private investment Exports of goods and

non-factor services Imports of goods andnon-factor services

CENTRAL GOVERNMENT

Revenues

Taxes and non-taxes GrantsExpenditures

Current Capital

Overall balanceFinancing

Domestic financing (net) Banking system Nonbanking sector

Balance of Payments

CURRENT ACCOUNT Exports of goods andnon-factor services

Imports of goods andnon-factor services

Factor services (net) Transfers (net)

Official

Private grants Remittances

MONETARY SECTOR

Monetary Authorities Net Foreign AssetsNet domestic assets: Net credit to central govt. Credit to banks Other items (net)

Reserve money

CAPITAL ACCOUNT

Direct investmentMedium/ long-term

capital flow (net)Short-term capital (net)Overall balance

Change in net foreign assets

Deposit Money Banks Banks' reserves

Net Foreign AssetsNet domestic assets: Net credit to govt. Credit to private sector Other items (net)

Liabilities to monetaryauthorities

Private sector deposits

CPI Inflation, GDP Deflator,Interest Rates and Exchange Rate


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Interrelationship between the internal and external sectors of an economy can be seen ingreater detail by distinguishing between the private and government sectors. Privatesaving and investment (Sp and Ip) and government saving and investment (Sg and Ig)are identified as:

SI = Sp+SgIpIg (8)

Use of the definition of the externalcurrent account from equation (1) then gives:CAB = (SpIp) + (SgIg) = SI (9)

Equation (9) shows that the private savings-investment balance plus the governmentfiscal balance equals the current account balance. It also implies that, if governmentsector dissaving is not offset by net saving of the private sector, the current account willbe in deficit. More specifically, the equation shows that the budgetary position of thegovernment (Sg-Ig) may be an important factor influencing the current account balance.

Government deficit is financed by borrowing from the domestic sector, borrowing fromthe external sector and borrowing from the central bank. All these factors have influenceson the domestic capital and financial markets and also on the balance of payments.

Economists generally agree that a persistent fiscal deficit may ultimately spill over thecurrent account deficit in the balance of payments. On the converse, a sustained currentaccount deficit may reflect persistent government spending in excess of receipts, andsuch excess spending may suggest that fiscal tightening is the appropriate policy action totackle both fiscal and balance of payments problems.

We also know thatCAB = NKA+RT = SI (10)

Equation (10) shows that the current account balance is necessarily equal (with signreversed) to the net capital and financial account balance plus reserve asset transactions.This relationship shows that the net provision, as measured by the current accountbalance, of resources to or from the rest of the world mustby definitionbe matchedby a change in net claims on the rest of the world.

It may be useful to rewrite CAB as:SI = CAB = TB+SB+FIB+TRANB = NKA+RT (11)

WhereTB = Merchandise trade balance = Merchandise Exports Merchandise ImportsSB = Non-factor service balance (travel, tourism, financial, business, ICT etc.)FIB = Factor income balance (interest, dividends, wages, rent, royalties etc.)TRANB = current transfer balance (official grants, private grants, remittances)

For Nepal, in general, TB and SB are negative, while FIB and TRANB are positive.

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6.3 Specification of the Model and Work Plan

While keeping these basic identities and macroeconomic balance equations intact,various variables in the model will be categorized either as exogenous variables orendogenous variables. While exogenous variables will be determined outside the model,

suitable econometric relations will be specified for the endogenous variables on the basisof standard economic theories.

Items in different sub-models will be estimated and calibrated by suitable econometrictechniques and tested on the basis of standard goodness of fit statistics. The models willbe fully developed and documented in the subsequent reports.

The proposed Work Plan Matrices of the Consultants are presented in Annex-7.1 toAnnex-7.4.MajorWork Plan Milestones are summarized below:

1. Preparation of the Draft Inception Report by 10 September 2009

2. Finalization of the Inception Report 22 September 2009.3. Review the NMEM and identify deficiencies and their causes by 09 Oct 20094. Conduct research & explore data sources to upgrade the NMEM by 09 Oct 2009

5. Report on the choice of software and hardware by 16 Oct 2009

6. Set up Workstations for Software/ hardware Testing by 2nd January 2010

7. Finalize choice and purchase of software/hardware by 15th January 2010

8. Finalize the upgraded NMEM by 31 January2010

9. Undertake research to develop a DSGE-type model for Nepal by 24 Feb 2010

10. Conduct multi-stakeholders seminars/ workshops on the features of the two models by15 May 2010

11. Preparation of macroeconomic and fiscal envelope for the Ministry of Finance as pre-budget inputs for preparation of the Budget for 2010-2011 by 31May 2010

12. Develop and calibrate the DSGE-type model by 31 May 2010.

13. Develop a user manual, including calibration methodology, to undertake quantitativemacroeconomic analysis using the DSGE model by 25 June 2010

14. Conduct seminars/ workshops on the features of the two models by 30 Sep 2010

15. Provide on-the-job training to three staff from each of the agencies NRB, CBS, NPC,MOF and the Department of Economics, Tribhuvan University, and other relevantagencies (staff will be selected in close coordination with the executing agency, SteeringCommittee, and the Technical Committee) by 30 Sep 2010.

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7. Brief Descriptions of Works

7.1 Updating the Nepal Macroeconomic Model developed by ADB

In 2005 ADB (Ra, Sungsup and Chang Young Rhee 2005) developed the Nepal

Macro-economic Model (NMEM) and simulated the model to carry out alternativescenario analysis. The model was also calibrated to measure the economic costs ofconflict in terms of the effect of declining development expenditures on economic growth(Ra, Sungsup and Bipul Singh 2005).

NMEM is a medium-sized annual Keynesian model and consists of 20 behavioralequations and 17 identities. Of the 59 variables in the system, 37 are endogenous and 22are exogenous. There are 5 building blocks in the NMEM viz. final demand, prices, creditand money, government, and the balance of payments blocks. Final demand is the sum ofprivate consumption, government consumption, private fixed investment, governmentfixed investment, increase in stock or inventory, and net exports. In NMEM, development

expenditure is a determinant for the private fixed investment, public fixed investment andpublic consumption.

A critical review of the model leads to the following limitations:

(a) Model considers only the demand side of GDP, but does not consider the supplyside of the real sectors.

(b) Similarly, money, credit and price blocks were not fully developed and did notconsider the supply side and the role of expectations.

(c) The Government block was the weakest block with only equation for the non-taxrevenue and all other variables were defined by simple accounting identities.Basically, all the fiscal variables such as taxes, current and capital expenditure aretreated as policy variables and left to be decided by the policy makers. This is nota very convincing assumption because taxes and government expenditures alsodepend on economic prospects, composition of GDP and many other variables.

(d) Similarly, balance of payments block were not well developed. It consideredonly merchandise exports and merchandised imports but did not endogenize theother components in the current account (such as services and remittances). In thecapital account, loans and amortization was endogenized, but the underlyingeconometric relations are less convincing.

(e) The model also needs to be updated and upgraded on the basis of new dataavailable for the national accounts and balance of payments.

The NMEM will be reviewed more critically and modifications will be suggested in thenext report. While doing so, due consideration will be given to the availability data base,statistical test and calibration techniques, computer algorithms, and available hardwareand software capabilities, and technical manpower in the NRB, MOF and other budgetaryagencies which are likely to use the updated NMEM for budgeting, planning andmonetary and financial programming.

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7.2 Building up of a Dynamic Stochastic General Equilibrium Model

The model has been described fully with its relative merits and demerits in terms ofobjectives, data requirements and test and calibration techniques in section 3.13 in the

Annex-3. As the name indicates, DSGE models are dynamic, studying how the economyevolves over time. They are also stochastic, taking into account the fact that the economyis affected by random shocks such as technological change, fluctuations in the price ofoil, or errors in macroeconomic policy-making.

International best practices like the ECB Model and the USA Model will be studied andsuitable model will be formulated and estimated for forecasting and planning by theNRB, NPC and the Ministry of Finance.

7.3 Capacity Building and Training

The consultants shall work in close collaboration with the concerned authorities in thegovernment department viz. MOF, CBS, NPC and the National Rasta Bank with a viewto transferring knowledge and equipping the staff with the skill required to manage andmaintain the models in future. Consultants will demonstrate the use of the models bysimulating actual policy questions raised by the authorities.

After the Models have been fully developed, macroeconomic modeling experts shallcarry out a series of simulations to check for consistency, predictability and reliability of both the models, and shall validate both the models at multi-stakeholders workshop.Macroeconomic modeling experts will also advise the authorities on the most appropriatehardware and user-friendly software package for the purpose of maintaining the models.

7.4 Support the IT Group for Software and Hardware Selection

In consultation with the Team Leader, local econometrician and the local IT Specialistjointly made a Rapid Survey on the current status of ICT capabilities in the MOF, CBS,NPC and NRA. As per their assessment, all the four agencies have rich database, welldeveloped website, and reasonable hardware and software capabilities. However, licensesof major software have expired and the software is outdated and need upgrading.Agencies do not have uniform operating systems and software capabilities. All theseissues will be studied in details and suitable recommendations will be given.

The main observations of the Consultants drawn from the Rapid Survey are summarizedbelow:

a) Data Bank and Warehouse: All four agencies regularly update their database andmaintain soft version of data in various software depending on the size and nature of thedatabase. CBS maintains database mostly in MS-Excel, Oracle, STATA and SPSS; NRBin MS-Excel and SPSS; MoF in Oracle and MS-Excel; and NPC in SPSS, Oracle andMS-Excel. For time-series data on major Macro variables, all four agencies use MS-

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Excel and share their data via emails. However, time interval and frequency of datapublication varies from agency to agency depending on the nature of data. There is nouniformity in the storage and software format among the agencies.

b) Capacity for Data Analysis: Capacities of agencies differ in terms of data analysis

skill. CBS is very competent in statistical analysis but lags in macro-econometricforecasting. NRB is equipped with both statistical techniques and limited macro-econometric modeling skills. NRB staffs are technically competent and use econometricmethods in course of their researches, but such activities are not systematically followeddue to pressures from routine works. NPC has limited capacity on statistical analysis buthas experience of modeling exercises that were discontinued due to work pressures andlimited designated staffs. MOF is less competent in statistical analysis and econometricmodeling skills as compared to other agencies.

c) Capacity for Data Retrieval: Capacities of the four agencies differ in terms of dataretrieval. While four agencies have capacity to retrieve data from MS-Excel, CBS, NRB

and NPC are partially equipped to retrieve data from SPSS and Eviews. They also havesome knowledge on how to transfer the database from one software to another software.

d) Data Availability in Web: All four agencies have their own websites, which areupdated on regular basis to upload new data. The data are generally uploaded either inMS-Excel format or in Adobe Reader files.

e) Hardware Capacity: All four agencies do have sufficient computers of good qualitythat are sufficient to run software programs like EXCEL, SPSS, STATA and Eview andto use the facility of internet/ emails.

f) Availability of Software: The status of the four agencies is mixed in terms ofavailability of software as indicated below. It is observed that most of the softwareversions are outdated and in many cases the licenses have expired.

Agencies Available Software

CBS STATA, SPSS and MS- Excel

NRB Eviews 3.1, SPSS and MS- Excel

NPC Eviews, SPSS and MS- Excel

MOF MS- Excel and Eviews 4.1

g) Human Resource: CBS staffs have very good statistical skill but very few of them

have the experience of modeling. NRB staffs, in general, possess very good statistical andmodeling skill. NPC has very limited human resource but the available few are verycompetent in statistical and modeling shill. MOF has a very small pool of humanresource having sufficient statistical and modeling skills.

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7.5 Preparation of Manuals and Organizing Workshops

As discussed earlier, substantial time will be spent to prepare manuals and fulldocumentation on basic concepts, structure of the models, data base, computeralgorithms, test and calibration techniques. portion, so that any other group can test,

calibrate and run the model, even after the present modelers and consultants have left themodeling project. Once the Models are fully developed and calibrated, results will bepresented in the multi- stakeholders Workshops.

7.6 Preparation of the Inception Report

This is the Inception Report being prepared by the International Modeling Specialist inconsultation with the major stakeholders and vital inputs from the local consultant. TheInception Report is expected to be completed by the 10 th September, 2009, well beforethe stipulated time of one month as envisaged under the Terms of Reference. List ofofficers consulted for preparation of this report is giver in Annex-8.

7.7 Preparation of the Quarterly Progress Report

The modeling works with all its components are required to be completed in six personmonths (132 working days) on intermittent basis in four phases during 15 months fromAugust 2009 to October 2010. The Work Plan Matrices of the Consultants presented inAnnerx-6.1 to Annex-6.4 clearly indicate the distinct four phases of the work which will be completed within stipulated time. The Progress Report will be submitted aftercompletion of each phase of works.

7.8 Preparation of the Terminal Report

At the end of the Project, a Terminal Report will be prepared indicating the overall scopeand achievements of the project, constraints faced, lessons learnt, issues and challengesfor way forward, and suggested roll out plan so that the project comes to a logical end.

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8. Review and Upgrading the Nepal Macroeconomic Model

8.1. Review of the Nepal Macroeconomic Model developed by ADB

As mentioned in section 7.1 earlier, ADB supported the Government of Nepal indeveloping a comprehensive macroeconomic model in 2005Nepal MacroeconomicModel (NMEM)as a part of TA for Strengthening Institutional Capacity for PublicDebt Management. Apart from being used by the Government for public debtsustainability analyses, Nepal Rasta Bank (NRB)the central bank of Nepalhas alsobeen using the NMEM for economic forecasting. However, the NMEMs utility hasbecome limited due to some major developments in recent years.

The major characteristics of the NMEM are:

(a) The NMEM is a basically Keynesian income-expenditure model in which thedemand side determines GDP.

(b) The supply side is not explicitly specified as the aggregate productionfunction is not estimated.

(c) Its basic features are drawn from the Korea Development Institute (KDI)macro model that had been used to design successive 5-year economicdevelopment plans in Korea. Due to the lack of quarterly data in Nepal the NMEM is an annual model while the KDI used a quarterly macro-econometric model.

(d) The NMEM is a mid-sized model with 37 equations. A medium-sized modelhas an advantage in policy analysis as it incorporates more detail of thestructure of the economy.

(e) The NMEM consists of 20 behavioral equations and 17 identities. Of the 59variables in the system, 37 are endogenous and 22 are exogenous. The NMEMdistinguishes policy variables from simple exogenous variables since these policy variables are different from simple exogenous variables that aredetermined by non-economic forces or foreign sectors. Taxes, regularexpenditures, development expenditures, foreign borrowing, and the exchangerate were taken as policy variables in the NMEM.

(f) Given the peg of the Nepalese rupee to the Indian Rupee, monetary variablesare not considered as policy variables. Table-8.1 lists the exogenous,endogenous and policy variables and Table-8.2 presents the set of best fittedequations for the model.

(g) The NMM attempts to incorporate Nepals strong economic ties with India ininternational transactions although economic relationships with othercountries are also becoming important.

(h) The impact of the exchange rate on trade in Nepal is quite limited since theNepalese rupee is pegged to the Indian rupee and India is the major tradingpartner of Nepal. The exchange rate variables were incorporated in the tradeequations since the changes in the exchange rate with respect to the US dollar

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can affect trade with the rest of world by changing the relative prices withother countries.

The Nepal Macro-economic Model (NMEM) was tested and calibrated on the basis oftime series data for the sample period from FY1975 to FY2004. Then the model was

simulated to carry out alternative scenario analysis for formulation of the Tenth Plan. Themodel was also calibrated to measure the economic costs of conflict in terms of the effectof declining development expenditures on economic growth (Ra, Sungsup and BipulSingh 2005).

There are 5 building blocks in the NMEM viz. final demand, prices, credit and money,government, and the balance of payments blocks. Final demand is the sum of privateconsumption, government consumption, private fixed investment, government fixedinvestment, increase in stock or inventory, and net exports. In NMEM, developmentexpenditure is a determinant for the private fixed investment, public fixed investment andpublic consumption.

Limitations of the Model of the Model have already been discussed in section 7.1. Sothese are not repeated here. In brief Model considers only the demand side of GDP, butdoes not consider the supply side of the real sectors, which put basic constraints on thegrowth and development of a developing country like Nepal. In addition, monetary,financial and price blocks, government block, and balance of payments block were notfully developed and did not consider the supply side and the role of expectations ofeconomic agents. The model also needs to be updated on the basis of new data availablefor the national accounts and balance of payments.

The utility of NMEM in the national polity analysis has been limited due to thefollowing reasons: The structure of Nepals economy has changed significantly. Agriculturescontribution to GDP has declined fast whereas the services sectors contribution hasgrown rapidly compared to other sectors of non-agriculture sectors. It is interesting tonote that the industrys share of GDP has remained more or less unchanged. Thenational accounts also underestimate certain incomes, such as migrant workersremittances, which have grown sharply since 2004. There have been some major revisions of basic concepts and standards of keymacroeconomic variables such as national accounts, government finance, balance ofpayments and prices since the NMEM was developed. In view of these changes, it is necessary to upgrade the NMEM for analytica

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