KATHMANDU: Nepal Rastra Bank’s decision to hold its policy rate corridor unchanged for a second consecutive year, at a time when the fiscal authorities are simultaneously pursuing the largest budget in the country’s history, represents a coordinated attempt at macroeconomic policy alignment rather than a routine renewal of the status quo. Read alongside the accompanying Macroeconomic Report, the policy exposes both the logic and the fragility of Nepal’s current growth strategy: an economy attempting to escape a multi-year output gap through demand-side stimulus, even as several of the supply-side and institutional constraints that produced that gap in the first place remain largely unaddressed.

The starting point for any assessment has to be the output gap itself. NRB’s own Hamilton- and HP-filter estimates place Nepal’s economy in a state of prolonged negative output gap since the onset of the COVID-19 pandemic in 2020, narrowing only gradually and still open as of 2025/26, with actual growth of 3.85 percent running below an estimated potential of around 4.2 percent. In standard macroeconomic terms, a negative output gap of this magnitude would normally argue for continued monetary accommodation, since there is spare capacity to absorb additional demand without immediately generating inflation.

NRB’s decision to leave the policy rate at 4.25 percent, the standing deposit facility at 2.75 percent, and the bank rate at 5.75 percent is consistent with that textbook logic. What complicates the picture, however, is that Nepal’s slack is not being absorbed through credit-driven private investment in the way conventional monetary transmission would predict. This is precisely the “credit conundrum” the Economic Research Department itself flags: private sector credit growth of roughly 6 percent against a projected 12 percent, even with excess reserves of about Rs 1.1 trillion and a weighted average lending rate down to 6.7 percent.

IMF headquarters in Washington D.C.

This is a textbook illustration of what the IMF and other institutions have long described in emerging-market contexts as a broken credit transmission channel, where policy accommodation lowers the price of credit without correspondingly lifting its quantity, because balance-sheet constraints on the supply side (deteriorating asset quality, capital adequacy pressure at the bank level) interact with demand-side caution among borrowers still recovering from the September 2025 political disruption and a stagnant collateral market in real estate.

The real estate dimension deserves particular attention because it sits at the intersection of credit policy and financial stability. Roughly three-fifths of total bank loans in Nepal are secured against land and buildings, a collateral concentration that is structurally similar to episodes seen in other emerging Asian banking systems, such as Vietnam’s property-linked credit stress in the early 2020s or, on a larger scale, China’s ongoing property-sector deleveraging since 2021.

In each case, a credit boom built substantially on collateral value rather than project cash flow eventually produces an asset price correction that then feeds back into non-performing loans, since falling collateral values make it harder for banks to recover stressed exposures even when the underlying gross NPL ratio, at 5.6 percent for Nepal’s banking system as of April 2026, still looks statistically manageable by regional standards.

The more forward-looking indicator is the watchlist category, loans not yet non-performing but showing early stress, which has climbed from 6.7 percent in mid-2023 to 11.1 percent by April 2026. NRB’s stated response, shifting the lending model toward project-based and character-based underwriting supported by institutionalized credit scoring, mirrors reforms the Reserve Bank of India and Bangladesh Bank have both pursued with mixed success; the structural challenge in all three cases is that collateral-based lending persists because credit information infrastructure and contract enforcement mechanisms for cash-flow lending remain underdeveloped, meaning the transition is likely to be gradual rather than immediate.

On the external side, Nepal’s reserve position illustrates a common tension in remittance-dependent economies between headline strength and underlying composition. Gross reserves of Rs 3,704.5 billion (USD 24.19 billion), covering a record 19.1 months of imports, comfortably clear the traditional three-month adequacy benchmark still applied to economies with restricted capital accounts, such as Nepal, under the IMF’s own reserve adequacy framework.

Yet roughly a quarter of the year’s reserve accumulation is attributable to pure valuation effects from the Nepali rupee’s depreciation against the US dollar rather than genuine new inflows, and remittances alone, at close to 29 percent of GDP in the first ten months of 2025/26, dwarf export and tourism earnings combined.

Tourists in Mustang. File photo

This pattern is not unique to Nepal; the Philippines and several Central American economies exhibit similarly remittance-heavy external accounts, and the lesson from those cases is that reserve adequacy calculated primarily on import coverage can understate underlying vulnerability if remittance flows themselves are exposed to a common shock, in Nepal’s case, labor market conditions across the Gulf states and the wider West Asia region, from which about 41 percent of total remittances originate.

The fact that remittances actually grew by 41.2 percent through a period of active war in that same region is a reassuring data point about labor market resilience among Gulf employers, but it should not be mistaken for evidence that the underlying dependency itself has become less risky.

The exchange rate channel offers a further illustration of how externally-determined shocks propagate through Nepal’s economy almost mechanically. Because the rupee is pegged to the Indian rupee at Rs 1.60 to one Indian rupee, and the Indian rupee itself depreciated by nearly 6 percent against the US dollar between January and May 2026 amid capital reallocation toward US assets during the artificial-intelligence-driven rally in American equities, Nepal imported that depreciation in full despite having no independent monetary or trade imbalance of its own driving the move. This is the classic cost of a fixed peg: monetary policy autonomy is subordinated to whatever the anchor currency, in this case the Indian rupee via the US dollar cross-rate, does.

The corresponding inflation divergence between Nepal and India from April 2026 onward, where Nepal’s inflation rose faster because Nepal Oil Corporation passed through global crude price increases immediately while India’s government held domestic fuel prices administratively stable, demonstrates that even under a fixed exchange rate regime, differences in fiscal and administrative pricing policy for a single traded commodity, oil, can meaningfully decouple two otherwise tightly linked price levels.

The fiscal-monetary policy mix for 2026/27 is unambiguously expansionary on both fronts simultaneously, which is a deliberate and somewhat unusual alignment. The government’s Rs 2,124.3 billion budget, its largest ever and about 25 percent above the prior year’s revised estimate, doubles the income tax exemption threshold and cuts the top marginal rate from 39 to 29 percent, a supply-side tax cut intended to work through the demand side by boosting disposable income and consumption.

NRB’s decision to hold interest rates steady rather than tighten in response to this fiscal expansion effectively validates the government’s demand push, betting that the negative output gap provides enough slack to absorb both fiscal and monetary accommodation without a disorderly acceleration in inflation. This is analogous to the coordinated fiscal-monetary stimulus many emerging markets attempted in the years following the 2008 global financial crisis, and the historical lesson from those episodes, well documented in IMF Article IV consultations across multiple economies during that period, is that the success of such coordination depends critically on whether capital spending is actually executed, since recurrent-heavy spending tends to boost short-term consumption without building the productive capacity that would allow the economy’s potential output to rise alongside actual demand.

Nepal’s own track record here is the report’s most understated but arguably most consequential finding: capital expenditure execution running at only 32.5 percent of its annual target and averaging around 60 percent over the past three years, while debt servicing costs already exceed capital spending in absolute terms. Public debt, having risen from 40.4 percent to 44.9 percent of GDP over four years, remains assessed as low risk of distress by the joint World Bank-IMF debt sustainability framework, but the composite indicator underpinning that assessment has been gradually deteriorating since 2020, a trend line worth monitoring even if the current risk classification holds.

The principal risk to this entire framework is external and largely outside NRB’s control: the durability of the June 17, 2026 memorandum of understanding between the United States and Iran. The de-escalation has already reopened the Strait of Hormuz, through which roughly a fifth of global oil trade transits, and Iran has resumed substantial crude exports, pulling prices back down from the wartime spike above USD 100 a barrel.

NRB’s inflation forecast of around 5.5 percent for 2026/27 is built on the assumption that this de-escalation holds through the year and that Iranian crude continues re-entering global markets. Given that core issues, including the governance of the Strait of Hormuz itself and the future of Iran’s nuclear and missile programs, remain unresolved even under the memorandum, this assumption carries meaningful tail risk.

A renewed escalation would hit Nepal on two fronts simultaneously through the same transmission channels already described: a fresh oil price shock feeding directly into inflation via Nepal Oil Corporation’s pricing mechanism, and a potential disruption to Gulf labor markets threatening the remittance flows that underpin both the current account surplus and the headline reserve position.

In that sense, Nepal’s 2026/27 macroeconomic outlook, notwithstanding the domestic reform agenda NRB and the government have both articulated, remains substantially hostage to developments several thousand miles away in the Persian Gulf, a vulnerability that no amount of domestic monetary policy calibration can fully offset.