Monetary Policy 2025/26: Balancing Act or Policy Pitfall
As Nepal navigates a complex terrain of global economic uncertainty, will the monetary policy deliver on economic aspirations of the country, especially the financial and business sectors? On the one hand is the need to stimulate growth and enhance economic resilience, while on the other is the responsibility of keeping inflation in check in an environment where global inflationary pressures continue to impact markets worldwide.
In this opinion segment of Business 360, a diverse group of experts, each with a unique vantage point on Nepal’s economic landscape, offers their insights into the role of Nepal Rastra Bank (NRB) and the effectiveness of its strategies moving forward. They share their perspectives on critical issues that define Nepal’s monetary policy: impact of NRB’s policy cuts on economic growth, challenge of rising non-performing loans (NPLs), nation’s over-reliance on foreign exchange reserves, and risks of clinging to traditional monetary tools. Together, they provide a thought-provoking exploration of the country’s fiscal future, offering both praise for certain policies and caution about potential pitfalls. Their collective insights push the boundaries of conventional thought and encourage policymakers to think critically about both immediate needs and long-term sustainability.
Nara Bahadur Thapa, Former Executive Director of Nepal Rastra Bank; Kalpana Khanal, Senior Research Fellow at the Policy Research Institute; Prof Dr Ram Prasad Gyanwaly, Head of the Central Department of Economics at Tribhuvan University; Menuka Karki, a PhD economist and visiting faculty member at Kathmandu University; and Baikuntha Aryal, former Chief Secretary of the Government of Nepal, offer a rational view on the current state of Nepal’s monetary tools and also a comprehensive understanding of Nepal’s monetary policy in the years ahead.
Policymakers need to go beyond pumping more liquidity into the system. What Nepal needs is productive absorption of liquidity into real investment and growth. Financial inclusion must also be prioritised to safeguard depositor interests. Otherwise, monetary policy risks becoming a blunt instrument in a fragile economy.
NARA BAHADUR THAPA
Former Executive Director, Nepal Rastra Bank
With global inflationary pressures still persisting, will NRB’s policy cuts aimed at stimulating economic growth while targeting inflation at around 5% be effective?
Nara Bahadur Thapa: The global economy is at a critical juncture. Policy-induced uncertainty is reshaping economic trade-offs. Barring a few exceptions, growth is tapering off while inflation is easing. Nepal mirrors this global trend of sluggish output and subdued inflation, much like in the post-Covid phase.
Nepal faces a macroeconomic paradox. Monetary conditions are loose, yet growth remains anaemic. Inflation is low but momentum has yet to pick up. The pressing challenge for Nepal is not runaway inflation but a stagnant economy stuck in low gear.
Against this backdrop, NRB’s policy rate cuts are a predictable move aimed at stimulating growth. However, they are unlikely to move the needle.
Nepal has been stuck in a quasi-liquidity trap for over two years. Both policy and market interest rates hover near historic lows. Banks are awash with excess liquidity. Yet, private sector credit demand remains weak, so liquidity is pooling instead of flowing.
The issue runs deeper than just the cost of capital. Investor confidence is low, expected returns are uncertain, and structural bottlenecks persist. In the absence of active demand, the transmission mechanism breaks down.
In such an environment of persistent economic underperformance and low interest rates, conventional rate cuts fall short on two fronts.
First, policy cuts should not be mistaken for ends in themselves. It is not that monetary policy is misguided but rather that it is outmatched by the scale and nature of the economic malaise. The real challenge lies in idle liquidity, not insufficient liquidity.
Second, rate cuts risk exacerbating inequality in financial access. In practice, when interest rates fall, credit tends to flow upward, not outward. This disproportionate concentration of financial access ends up favouring entrenched interest groups at the expense of the vast majority of small depositors, whose modest savings collectively power the financial system.
Monetary policy ought to be agile. Policymakers need to go beyond pumping more liquidity into the system. What Nepal needs is productive absorption of liquidity into real investment and growth. Financial inclusion must also be prioritised to safeguard depositor interests. Otherwise, monetary policy risks becoming a blunt instrument in a fragile economy.
Kalpana Khanal: Nepal’s monetary policy now relies on the interest rate corridor which comprises the upper bound (the bank rate), the lower bound (the deposit rate), and the policy rate is positioned midway. Theories suggest that short-term interest rates, particularly those on interbank loans, need to linger between the two bounds of the corridor, at around the policy rate itself.
In FY 2082/83, Nepal Rastra Bank trimmed every component of the corridor. The policy rate, which serves as the corridor, was reduced by half a percentage point. The upper bank rate was adjusted down from 3% to 2.75%, while the lower deposit rate was decreased from 3% to 2.75%, marking a quarter-point reduction on both fronts. These reductions come in a context where interest rates were already trending downward and loan interest rates had significantly decreased, contributing to a gradual rise in credit demand.
In this context, keeping the policy rate constant could have continued the flexible approach of the monetary policy, especially because our bank rates and policy rates were already lower than India’s. However, the rates were further reduced, which will likely lead to lower deposit interest rates. When deposit interest rates decrease, loan interest rates may also fall somewhat, but the extent of demand increase depends not just on interest rates. A deeper issue arises when real interest rates turn zero or negative; excessively low interest rates may discourage depositors, who might then prefer to spend rather than save.
This shift in behaviour could lead to rising asset prices, especially in real estate. If people choose to invest in property rather than keep money in banks and if deposits shrink, the current liquidity surplus, which is largely driven by high deposit levels, may not be sustainable in the long run.
Furthermore, as returns on domestic savings diminish, the risk of capital flight rises. If monetary policy simply promotes consumption by reducing interest rates, it might undermine its own goals. Instead, policies should ensure that financial resources are channelled toward productive sectors within the domestic economy.
In summary, although interest rate cuts may offer short-term relief and stimulate demand, a more balanced approach is needed to promote long-term investments.
Prof Dr Ram Prasad Gyanwaly: While interest rate cuts by NRB may have been intended to spur economic growth by encouraging investment, their effectiveness is questionable. Despite historically low interest rates and excess liquidity in the banking sector, private sector demand for investment has not increased, and the private sector investment-to-GDP ratio has remained stagnant. This suggests that the interest rate is not the primary issue facing the current macroeconomic climate. Interest rate cuts may not be sufficient to boost economic growth in Nepal.
The main problems contributing to the sluggish growth are a lack of business confidence and unspent capital expenditure. With international inflation slowing down, Nepal’s target of 5% inflation is easily achievable, as about half of Nepal’s inflation is imported and inflation in India is also low. Furthermore, intentionally lowering interest rates poses a problem for depositors. The real interest rate is negative for them, causing a large portion of the population to suffer. Decreasing interest rates threatens the preservation of the value of money.
Menuka Karki: Nepal Rastra Bank’s recent policy cuts aim to spur economic growth by lowering borrowing costs, promoting investment, entrepreneurship and job creation. This expansionary monetary stance aligns with Nepal’s pressing need to revive momentum after years of subdued growth. The expectation is that increased economic activity will generate a multiplier effect: higher employment, increased incomes and rising demand for goods and services, which is precisely what the economy needs now.
However, this monetary expansion comes with an inherent tension: economic growth and inflation are indeed two sides of the same coin. As output expands and incomes rise, prices tend to follow suit. Yet, it is important to recognise that moderate inflation, driven by growth, is not inherently harmful. Rising wages improve living standards and appreciating asset values build wealth, both of which can support further economic dynamism.
The challenge lies in maintaining this balance, particularly in the current global context where inflationary pressures, stemming from supply chain disruptions, volatile commodity prices and geopolitical uncertainties, remain elevated. Nepal’s small, open economy is especially vulnerable to imported inflation, complicating the central bank’s task of stimulating growth without fuelling excessive price rises.
Monetary policy alone cannot walk this tightrope. It requires nuanced coordination with fiscal policy, structural reforms and targeted interventions. For example, enhancing domestic production and supply chain resilience can help mitigate imported inflation. Improving agricultural productivity and investing in infrastructure can ease bottlenecks that drive price spikes. Additionally, effective communication from NRB to anchor inflation expectations will be crucial to avoid wage-price spirals.
Ultimately, stagnation, where neither growth nor price stability are achieved, would be the worst outcome, undermining both livelihoods and macroeconomic stability. Therefore, while expansionary monetary policy is essential to kickstart the economy, it must be calibrated carefully, continually monitored and complemented by broader economic reforms to ensure that growth is sustainable and inclusive, without unleashing uncontrollable inflation.
Nepal stands at a critical juncture: embracing growth with vigilance and managing inflation with pragmatism, is the path to resilient economic recovery in an uncertain global environment.
Baikuntha Aryal: Fiscal policy and monetary policy need to go hand in hand to achieve the targeted economic growth. Monetary policy is expected to support fiscal policy’s targets. The main objective of monetary policy is to contain the inflation balancing the money supply in the market. This fiscal year’s monetary policy by and large supports the fiscal policy, with inflation target at 5% and broad money supply target at 13%.
In recent years, Nepal has been experiencing moderate level of inflation. The 10-year average is just above 5% and mere 2.8% in the 11 months of last fiscal year. The broad money supply target in not high, compared to nearly 20% a few years ago, which might not lead to demand pull inflation. These indicate that the inflation target for this fiscal year is not difficult to achieve. However, containing inflation does not solely depend on the monetary policy, it also depends on the market practices, consumers’ awareness and administrative proactiveness.
As Nepal’s consumer market is largely influenced by imported goods, the global price hike also impacts Nepali market. We cannot reduce the import of goods and services immediately for at least three reasons: (1) Consumer pattern is such that imported goods have larger share, (2) Domestic production is far less than demand, even most of agricultural products are not sufficient, and (3) Most of the machineries and equipment necessary for development activities are imported. Moreover, the domestic supply chain is not strong enough to maintain the demand-supply equilibrium. Therefore, global inflation may have some impact. As the trend suggests, the global inflation rate is not expected to rise in 2025, except the uncertainty over current tariff war between the USA and other countries. However, it is likely that the price will drop in countries from where Nepal imports goods because of increased cost of export for them to the USA.
In totality, the inflation target for this fiscal year seems to be attainable. The administrative proactiveness for market regulation, consumer orientation and fair market practices should also be supportive to contain the inflation.
In the process of improving bank asset quality, as recommended by the International Monetary Fund (2025) Nepal needs to align the Asset Classification Regulation rules with a continuous repayment period of three months for reclassification for non-restructured/non-rescheduled loans, as prescribed by the Basel Committee on Banking Supervision (BCBS) standards, and ensure the banking sector is provisioned accordingly. Other efforts to improve bank regulation and supervisory practices need to be in line with international standards, by reviewing and amending our current capital, blacklisting and liquidity frameworks.
KALPANA KHANAL
Senior Research Fellow, Policy Research Institute
Given the current financial landscape, including rising non-performing loans, what measures should NRB take to ensure that the private sector credit growth target of 12% reaches productive and high-impact sectors?
Nara Bahadur Thapa: On the surface, the officially reported NPL ratio of around 5% for commercial banks may not seem alarming. However, industry insiders, economic observers and informal discussions suggest a far more precarious reality. Despite surplus liquidity, banks remain hesitant to lend.
Beneath this facade of compliance lie warning signs: loan evergreening, repeated rescheduling, and rising non-banking assets (NBAs). Together, these indicate that NPLs are underreported and likely have already crossed into double-digit territory.
As a result, commercial banks face significant capital pressures. The reported capital adequacy ratio (CAR) likely overstates their true financial strength.
To ease these strains, NRB’s 2025/26 monetary policy has introduced several regulatory measures. Banks can now treat provisions for NBAs as supplementary (Tier 2) capital. Real estate loan rescheduling has been extended. NRB is facilitating capital raising from the market. Working capital guidelines have stalled, while loan limits have been raised for individual investors in shares from Rs 150 million to Rs 250 million, and home and real estate loans from Rs 20 million to Rs 30 million.
These steps aim to boost bank credit flows to the private sector and meet the 12% credit growth target for 2025/26. Given the scale of regulatory forbearance, achieving this target appears feasible.
However, increasing credit volume alone risks misallocating funds into unproductive and speculative sectors. Globally, monetary policy is rarely, if ever, designed to stimulate risky or speculative lending as a growth strategy. Credit growth is meaningful only when it supports productive investment. To change course, capital must flow to sectors that generate jobs, innovation and productivity.
Kalpana Khanal: Given the current context of rising non-performing assets, with levels between 5% and 7% and a risk of further deterioration, NRB needs to accelerate the drafting of the Asset Management Act to facilitate the creation of a company for managing these assets. The process needs to be prioritised.
In the process of improving bank asset quality, as recommended by the International Monetary Fund (2025) Nepal needs to align the Asset Classification Regulation rules with a continuous repayment period of three months for reclassification for non-restructured/non-rescheduled loans, as prescribed by the Basel Committee on Banking Supervision (BCBS) standards, and ensure the banking sector is provisioned accordingly. Other efforts to improve bank regulation and supervisory practices need to be in line with international standards, by reviewing and amending our current capital, blacklisting and liquidity frameworks. NRB also needs to limit regulation and ensure it is targeted, timebound and phased out as soon as possible. And in relation to repayment related pressures in the banking sector, NRB needs to remain vigilant in identifying emerging vulnerabilities.
The monetary policy has adopted some recommendations offered by the High-Level Economic Reform Advisory Commission (HLERAC), which are some much needed steps in the right direction.
1. The monetary policy mentions that the ‘Foreign Investment and Foreign Loan Management Regulation, 2078’ issued by Nepal Rastra Bank will be amended to facilitate improvements in the economic and business environment and to increase investment.
2. The monetary policy also includes the proposal to establish an asset management company, as recommended by the HLERAC. Instead of using the Credit-to-Deposit Ratio (CD Ratio), the policy is now moving toward alternatives such as the Net Stable Funding Ratio (NSFR) and the Liquidity Coverage Ratio (LCR).
3. Currently, credit limits are set based on the ratio of loans to deposits. However, this provision has become outdated. As an alternative, banks can adopt ratios based on stable funding and internationally recognised minimum liquidity requirements, such as the proportion of high-quality liquid assets banks must maintain.
Prof Dr Ram Prasad Gyanwaly: The rise in non-performing loans within the banking sector is a consequence of the easy credit policies adopted during the Covid 19 pandemic. The sector now faces a dual challenge of increasing NPLs and excess liquidity. To address the NPL issue, NRB should strengthen its regulatory oversight. There are reports that loans are being diverted from productive sectors to unproductive ones, which contributes to the rise in NPLs and requires stricter monitoring. A more effective approach would be to implement an easy credit policy specifically for key sectors like export, manufacturing, small and medium enterprises (SMEs), and hydropower. Investing in irrigation projects to boost agricultural production could also be a good option.
To prevent the banking system from collapsing, the central bank must closely monitor and correct situations where loans are concentrated among a small number of individuals. If these borrowers default, NPLs could rise rapidly. Therefore, portfolio diversification is essential for the survival of the banking system.
Menuka Karki: Nepal Rastra Bank’s 12% private sector credit growth target offers promise but comes with challenges, especially amid rising non-performing loans (NPLs). While recent monetary policy measures, like lower policy rates, asset management companies, and SME incentives, set a positive tone, ensuring credit reaches truly productive sectors demands a focused, dual approach.
Expanding credit limits for house construction and stock market investments may boost real estate and equity markets but these sectors alone will not drive broad-based economic productivity. Coordinated fiscal efforts toward public infrastructure can provide a stronger multiplier effect.
Crucially, high NPL levels in key sectors constrain new lending to viable businesses. NRB must enforce strict asset-quality discipline through timely NPL resolution, tighter provisioning, and sectoral stress tests. Introducing conditional refinance facilities and partial credit guarantees targeted at manufacturing, export-oriented SMEs, agriculture, hydropower and climate-resilient infrastructure can direct funds where they matter most.
Temporary capital relief for productive-sector loans, paired with transparency measures like monthly credit flow dashboards, will enhance accountability. Strengthening credit infrastructure through comprehensive credit reporting, expanded collateral registries and faster legal recovery will further improve banks’ lending capacity.
This balanced strategy, cleaning up bank balance sheets while incentivising productive lending, will help translate credit growth into real economic gains, supporting jobs, incomes and sustainable development. Nepal’s financial sector can thus become a true catalyst for growth without compromising stability.
Baikuntha Aryal: The Nepali economy could not perform well in the last few years causing small aggregate demand, slowed economic activities, effect of worldwide pandemic and weak production sector. This has led NPL to increase remarkably to 5.24% in Chaitra 2081 – an increase of 1.26 percentage point from the previous year.
Few measures have been announced in the monetary policy for this fiscal year – increasing investment capacity by easing the loan management, strengthening the capital fund and establishing Assets Management Company (AMC) to manage non-performing non-banking assets.
Weak economic performance and the private sector’s reluctance to invest in production present a significant challenge to achieving credit growth targets. With stagnant aggregate demand and disincentives to investment, banks and financial institutions may shift their focus from expanding credit to managing existing loans if this trend persists.
Therefore, there should be a coordinated complementary between fiscal and monetary policy. To ease the investment climate, the government must streamline procedures, boost economic activities, including timely capital budget expenditure, and implement procedural and legal reforms to enhance private sector confidence. NRB, on the other hand, has to facilitate loan management of BFIs and boost private sector confidence.
The operationalisation of AMC is still a far option, as 5.24% NPL is not that high. But the central bank should closely monitor and enhance banking performance. Further, the central bank may support them by restructuring/rescheduling the existing loans, loan capitalisation and enhance the assets and collateral quality.
Nepal’s external sector is in a vulnerable position. The trade deficit for the first 11 months of Fiscal Year 2081/82 was Rs 1.397 trillion, indicating the annual deficit will be higher. While the country’s foreign exchange reserve of Rs 2.569 trillion (as of the same period) is a positive sign, it is not enough to cover two years of trade deficits. Although the Balance of Payments is currently in a surplus, its structure suggests it is vulnerable to a deficit. Remittance is a key contributor to foreign currency reserves but it is not a permanent source, as it depends on other countries’ manpower import policies. This highlights a serious limitation: the Nepali currency is not accepted internationally.
PROF DR RAM PRASAD GYANWALY
Head of the Central Department Economics
Tribhuvan University
Do you think Nepal’s heavy reliance on foreign exchange reserves i.e. 14.7 months versus a target of seven months might inhibit more proactive policy measures or investments that could possibly stimulate long-term growth?
Nara Bahadur Thapa: Nepal has adopted a fixed but adjustable exchange rate regime pegged to the Indian rupee. This peg serves as the nominal anchor for monetary policy. In such a regime, it is not the exchange rate but the foreign exchange reserves and Balance of Payments that absorb external shocks.
NRB sets a floor for minimum foreign exchange reserves to ensure external stability, facilitate smooth international transactions, and meet external obligations. Given the nature of Nepal’s foreign exchange earnings, this floor is set at seven months of projected imports of goods and services. In contrast, advanced economies with more stable inflows typically maintain reserves covering only three months of imports.
On the surface, Nepal’s current reserves equivalent to 14.7 months of import cover signal strong external sector stability. A larger reserve buffer reduces vulnerability to external shocks, which is undoubtedly positive from a Balance of Payments perspective.
However, holding reserves far above the target carries significant opportunity costs. Idle reserves represent capital that could otherwise be deployed to build infrastructure, expand productive capacity, diversify the export base and create jobs. In effect, while ample reserves safeguard external stability, excessive accumulation may reflect a policy failure to channel resources into long-term growth.
Kalpana Khanal: Currently, loan rates have dipped below single digits. For investors, the key question is whether these low rates will remain stable over time. Without such assurance, long-term investments could slow down. This would steer the economy toward consumption-led growth rather than investment-driven growth, potentially worsening trade imbalances. Higher consumption, particularly of imported goods, can exert pressure on foreign exchange reserves. While current foreign reserves are strong enough to handle this for now, the monetary policy should focus on ensuring long-term stability and promoting investment and economic growth without causing fluctuations.
It is important to understand how NRB manages its foreign exchange portfolio. According to its 2023/24 annual report, the portfolio is primarily allocated to instruments like treasury bills and notes from central banks, time deposits with commercial banks, Chinese government bonds, and Bank for International Settlements (BIS) instruments such as FIXBIS and Medium-Term Instruments (MTIs). These choices align with the reserve management framework’s focus on safety, liquidity and return. Investment in gold remained below target due to its high price volatility.
Despite global monetary policy dynamics, such as the US Federal Reserve maintaining its policy rate at 5.25%-5.50% and the European Central Bank reducing its Euro policy rate to 4.25% in June 2024, NRB’s foreign exchange reserves achieved a weighted average return of 4.96%.
In summary, excess foreign reserves are not idle, they are actively invested in secure assets such as sovereign bonds from stable economies.
Prof Dr Ram Prasad Gyanwaly: Nepal’s external sector is in a vulnerable position. The trade deficit for the first 11 months of Fiscal Year 2081/82 was Rs 1.397 trillion, indicating the annual deficit will be higher. While the country’s foreign exchange reserve of Rs 2.569 trillion (as of the same period) is a positive sign, it is not enough to cover two years of trade deficits. Although the Balance of Payments is currently in a surplus, its structure suggests it is vulnerable to a deficit.
Remittance is a key contributor to foreign currency reserves but it is not a permanent source, as it depends on other countries’ manpower import policies. This highlights a serious limitation: the Nepali currency is not accepted internationally.
Nepal Rastra Bank has the authority to manage foreign exchange reserves, including investing them in the international market. Given Nepal’s limited capital goods production, most of these goods must be imported. Therefore, this is a crucial time to invest in the domestic productive sector and import capital goods for long-term growth. Increasing investment in the domestic economy will ultimately enhance long-term growth and strengthen the external sector.
Menuka Karki: Nepal’s foreign exchange reserves currently cover about 14.7 months of imports, more than double the widely accepted adequacy benchmark of seven months. This ample buffer offers undeniable macroeconomic stability especially for a small, import-dependent economy with a fixed peg to the Indian rupee. It helps maintain investor confidence, insulates against global shocks, and ensures the smooth functioning of trade and payments. However, such heavy reliance on maintaining oversized reserves carries opportunity costs that cannot be ignored. Much of these reserves are invested in low-yield foreign assets, generating minimal returns compared to what could be achieved by strategically channelling some of this capital into domestic productive investments. An overly conservative stance may inadvertently limit more proactive policy measures or bold investments critical for Nepal’s long-term structural transformation.
History shows that abrupt policy shifts aimed at conserving foreign reserves such as sudden restrictions on Letters of Credit for certain imported goods can severely disrupt businesses and even lead to shutdowns. Such policy inconsistency has lingering effects on the private sector and may contribute to rising non-performing loans by disincentivising investment. Monetary policy should aim to foster a positive, stable environment that encourages business confidence and expansion, not create uncertainty.
To balance stability with growth, Nepal could consider creating a ‘sovereign development window’ within the central bank’s operational framework. This would allow a portion of excess reserves to be deployed in carefully structured, foreign-currency-denominated infrastructure bonds or blended-finance vehicles that attract private capital. Investments in renewable energy, high-value agriculture, technology-driven SMEs, and critical infrastructure would yield higher economic returns and foster resilience.
Ultimately, while prudence in reserve management remains essential, clinging too rigidly to large reserve buffers risks missing a vital opportunity to convert macroeconomic stability into sustainable growth. Nepal’s real challenge is not just to safeguard its economic cushions but to leverage them to build a more diversified, dynamic economy, one less dependent on remittances and better equipped to withstand future shocks.
Baikuntha Aryal: In recent years Nepal’s foreign exchange reserve has increased significantly. It is well above the requirement to manage import of goods and services. On one hand it is good that the country has a good cushion to manage international shocks but on the other hand it is the indication of inefficiency of economy. Therefore, NRB should immediately take measures to utilise this fund externally and internally.
The forex reserve could widely be used to incentivise domestic investment by providing hedging and currency swapping facilities in selected sector projects. It could also be used to strengthen the confidence of foreign investors to increase FDI in Nepal.
Policies to mobilise the reserves in development projects, export-oriented industries and quality infrastructure have to be adopted. There are a number of sectors, where private sector investment can be increased by utilising forex reserves – tourism, industries, hydropower, transmission lines, power trading, Information and Communication Technology (ICT), among others. Forex reserves could also be used to import advance technology and high-yielding machinery and equipment, that increases productivity.
Learning from the past experience of stressed external sector, the government and NRB should take proactive measures to manage import of not more than eight months and utilise the forex reserves to incentivise domestic investment in sustainable infrastructure and production sector, which is essential for the sustainable growth in economy.
Nepal’s foreign exchange reserves currently cover about 14.7 months of imports, more than double the widely accepted adequacy benchmark of seven months. This ample buffer offers undeniable macroeconomic stability especially for a small, import-dependent economy with a fixed peg to the Indian rupee. It helps maintain investor confidence, insulates against global shocks, and ensures the smooth functioning of trade and payments. However, such heavy reliance on maintaining oversized reserves carries opportunity costs that cannot be ignored. Much of these reserves are invested in lowyield foreign assets, generating minimal returns compared to what could be achieved by strategically channelling some of this capital into domestic productive investments.
MENUKA KARKI
PhD Economist and Visiting Faculty
Kathmandu University
How prepared is Nepal’s monetary policy to withstand external shocks? Should Nepal diversify its economic base or rely more on domestic production and innovation to shield itself from global uncertainties?
Nara Bahadur Thapa: Monetary policy must always stay true to its core mandate of ensuring price, financial and external sector stability. In the face of external shocks, NRB tends to rely on monetary approach to Balance of Payments. Given Nepal’s fixed exchange rate regime, managing domestic credit becomes the primary instrument to address external imbalances.
However, when NRB tightens credit to stabilise reserves, it comes at the cost of inadvertently dampening domestic economic activity. Monetary policy must therefore strike a careful balance for effective monetary management.
Monetary space exists when inflation remains low, reserve buffers exceed adequacy thresholds, and the financial system is stable with sufficient credit availability. Under such conditions, monetary policy can be proactively used to support economic diversification and growth. Interest rates can stimulate domestic production and job creation, so long as they remain above the zero lower bound.
However, Nepal currently faces a near zero-bound interest rate. In such a liquidity trap situation, conventional monetary policy becomes ineffective. NRB’s recent rate cuts are thus unlikely to stimulate the economy. What Nepal urgently needs is innovative policy that redirects credit toward productive sectors.
Kalpana Khanal: In the case of Nepal, the effectiveness of monetary policy is adversely impacted due to the impossible trinity or policy trilemma as proposed by economists Fleming (1962) and Mundell (1963). Nepal has adopted an exchange rate peg with India as the nominal anchor and the capital account is also closed, these practices in place limit the role of monetary policy. Because of the exchange peg, the price stability goal is also expected to be imported from the pegged currency which may question the independence of the monetary policy, including operating targets.
Therefore, to withstand external shocks it is crucial to maintain Nepali inflation and interest rate targets close to that of India. A higher deviation in inflation may overvalue domestic currency further and a higher interest rate differential may encourage capital flight.
Additionally, instead of completely relying on monetary policy for macroeconomic stability Nepal needs to plan and execute its fiscal policy to enhance domestic production, increase domestic employment, diversify
export base, and prepare a base for sustainable development.
Prof Dr Ram Prasad Gyanwaly: Nepal’s current expansionary monetary policy puts pressure on the external sector deficit under its pegged exchange rate regime, as the money supply becomes an endogenous variable. Both the Keynesian Mundell-Fleming model and the monetary approach to the Balance of Payments (BOP) suggest that a higher money supply, in the short run, leads to an external sector deficit. However, because Nepal’s BOP is currently in a surplus, the expansionary policy is not expected to harm the external sector at this time.
This policy does not exclusively focus on protecting the economy from external shocks. A greater reliance on domestic production would make the economy less susceptible to such shocks but Nepal’s huge trade deficit indicates weak domestic production. Although import substitution is a key way to minimise the effects of external shocks, this strategy is not explicitly addressed in the current monetary policy.
Financial markets are highly integrated and Nepal’s interest rate is currently lower than that of other South Asian countries, particularly India with which it shares close trade and cultural ties and an open border. On average, India’s deposit rate is 1.5% higher than Nepal’s. From the perspective of Nepal’s more than 50 million depositors, the real interest rate in commercial banks is negative, posing a threat of capital flight. While a small segment of society may benefit, the banking system still has excess liquidity.
Menuka Karki: Definitely we have to make our food system stronger. We learned that lesson during Covid as well. Being a landlocked country and being in the middle of two giants, we have to protect our supply chain. We have to invest in areas where we have comparative advantage and policies should incentivise the private sector to invest and make profit from the areas with comparative advantage. We also have to diversify our area. For that we need statistics of our productivity in different sectors, statistics of the factors of production and market opportunity for all inside and outside the country.
Nepal’s monetary policy has made important progress in building buffers against external shocks, maintaining robust foreign exchange reserves equivalent to nearly 15 months of imports, managing liquidity prudently, and operating within a stable fixed exchange rate regime pegged to the Indian rupee. These measures provide Nepal with a solid foundation to absorb short-term disruptions such as volatile commodity prices, fluctuations in remittance inflows, or shifts in India’s monetary stance. However, the inherent constraints of a pegged exchange rate and a small, open economy limit the policy’s flexibility in responding to sustained or large external shocks.
To enhance resilience, Nepal cannot rely solely on monetary policy tools. It must adopt a strategic, dual approach focusing on diversifying the economic base and strengthening domestic production and innovation. Diversification means reducing dependence on remittances and imported goods by developing sectors such as hydropower, manufacturing, agro-processing and technology-driven SMEs. This can be achieved through targeted industrial policies, investment incentives and fostering public-private partnerships that encourage value addition and export competitiveness.
Simultaneously, nurturing domestic innovation via improved access to finance, skill development and research infrastructure will boost productivity and reduce vulnerability to external price shocks and supply chain disruptions. This approach can also help develop import substitution industries, strengthening local supply chains.
Moreover, Nepal should complement these structural changes with enhanced financial sector reforms: expanding credit access to priority sectors through targeted refinance facilities and credit guarantees, improving credit information systems, and developing movable collateral registries to support SMEs and agriculture.
In summary, while Nepal’s monetary policy provides a crucial safety net, true economic resilience against global uncertainties requires deepening domestic capacities and broadening the economic base. Only then can Nepal mitigate the impact of external shocks effectively and sustain long-term, inclusive growth.
Baikuntha Aryal: Every country adopts precautionary measures to deal with those shocks. A balancing approach to strengthen domestic economy and maintain a sizeable cushion to manage external shocks is taken by most countries. However, the effectiveness of this approach hinges on the magnitude of such shocks and it is difficult to assess the scale of their potential impact.
Because the external sector is not under as much stress as before, the current monetary policy is liberal, aiming to boost private sector confidence and increase investment. With a foreign exchange reserve that is almost double what the country requires, immediate shocks can be managed. However, a key question remains: how prepared is this monetary policy to handle prolonged shocks? Therefore, the focus must shift to enhancing domestic production capacity through increased investment in the production sector and carefully managing the external sector, including foreign exchange reserves.
There is no doubt that the economic base should be diversified. But one has to be careful about the scale of those bases otherwise the cost of transaction could be higher and the economy may suffer further. If you take an example of the trade sector, it is said that Nepal’s trade cost is higher than neighbouring and other developing countries. Trade infrastructure apart, the cost of export is much higher because of small economies of scale of exportable commodities.
Relying on domestic production and innovation definitely is the priority. The current global trend is also in this direction but in an interdependent world, it might not be enough. Moreover, Nepal’s growth sector is heavily dependent on imported goods and services. Strengthening domestic production and fostering innovation also requires a significant amount of imported goods, services and technology. Therefore, Nepal might not be able to solely rely on domestic production as of now.
Therefore, a balanced approach of diversifying the economic base and strengthening domestic capacity is a must. Policies to promote export-potential sectors such as ICT and hydropower as well as tourism should be a priority, which can help to diversify the bases and enhance domestic capacity. Above all, flexible policies to boost investors’ confidence is a must.
The government and NRB need to adopt policies that facilitate the production sector both in goods and services. Less regulation with stringent criteria; timely intervention and adoption of corrective measures; good harmony and coordination in fiscal and monetary implementation; trust building between public and private sectors; legal and procedural reforms; eliminating administrative and procedural hassles; enhancing public and private sector capacity; promoting innovation; promoting and incentivising job creating sectors; and prioritising the leading growth sectors are some policies the government and NRB need to adopt at the earliest.
BAIKUNTHA ARYAL
Former Chief Secretary, Government of Nepal
Could Nepal’s reliance on traditional monetary tools, like interest rate cuts and reserve targets, be limiting the potential for more transformative and non-conventional approaches to shape a truly future-proof economy?
Nara Bahadur Thapa: Under normal conditions, traditional monetary tools like interest rate adjustments are effective in guiding economic policy. However, when interest rates approach the zero lower bound, as is the case in Nepal today, these tools lose much of their power.
Maintaining a foreign exchange reserve target acts as a strategic buffer. Reserves sufficient to cover at least seven months of prospective imports gives Nepal room for policy manoeuvre before reserves fall to critical levels that could trigger a crisis.
Yet, reserves should not be viewed merely as a passive safety net. The surplus above the minimum threshold can be leveraged to drive economic transformation. This calls for strong coordination between monetary and fiscal policy.
Over-reliance on traditional monetary easing poses two key risks. First, conventional tools are often ineffective at channelling excess reserves into long-term productive investment. Second, overly accommodative monetary policy risks misallocating capital into speculative or low-return sectors.
The government must step in to unlock the full potential of reserve buffers. While monetary policy has its limitations, well-designed fiscal strategies and structural reforms can mobilise idle excess reserve towards building infrastructure, boosting productive sectors and generating employment in Nepal.
Kalpana Khanal: Nepal should focus on strengthening its credit channel by expanding access to credit for rural areas, SMEs and other productive sectors. Despite having the highest credit-to-GDP ratio in South Asia, the quality of credit expansion is questionable, as bank lending has not adequately contributed to production and growth.
Another operational challenge for Nepal’s monetary policy is enhancing the effectiveness of the Interest Rate Corridor (IRC), which remains wide and is not symmetrically committed.
Furthermore, unbalanced financial sector development adds pressure to monetary policy. According to the IMF (2023), Nepal’s financial development index is 0.21 out of 1, with the money market index at 0.42 but the capital market index at a low 0.0006. Therefore, the money and capital markets need to be complementary for both short- and long-term financing.
Prof Dr Ram Prasad Gyanwaly: The domain of Nepal’s monetary policy differs from that of developed nations like the US, Germany, Canada and the UK, which have adopted inflation-targeting policies to preserve the value of their currency. Recently, India also adopted this policy. In contrast, Nepal’s monetary policy, as defined by the NRB Act, has multiple goals: price stability, external sector balance, financial stability and high-level growth. Therefore, its performance should be evaluated based on these broader objectives.
Nepal Rastra Bank is responsible for both monetary policy and financial sector regulation, as there is no separate regulatory body. While conventional monetary policy has a strong theoretical basis and is appropriate for Nepal’s monetary front, it is now time for NRB to absorb excess liquidity by issuing medium-term NRB bonds. Adopting this approach would help absorb the liquidity in the market and allow the economy to achieve a minimum positive real interest rate, addressing the current threat of negative real rates for depositors. This has led to questions about NRB’s role in printing money without preserving its value in the financial market.
Menuka Karki: Nepal’s monetary policy has long relied on traditional instruments including interest rate adjustments, reserve requirements and liquidity management, to stabilise the economy and promote credit growth. These tools remain vital, especially in supporting sectors like MSMEs, agriculture and priority industries. Recent initiatives such as setting up Asset Management Companies to tackle rising non-performing loans, sector-specific lending guidelines, and improvements in credit infrastructure demonstrate progress toward a more resilient financial system.
However, as Nepal seeks to build a truly future-proof economy, this conventional toolkit may no longer be sufficient. Traditional monetary tools primarily influence demand and liquidity but have limited reach in driving structural transformation, technological innovation and climate resilience which are critical components for sustainable long-term growth.
To unlock transformative potential, Nepal must broaden its monetary policy framework to include non-conventional, forward-looking measures. This means integrating green and sustainability-linked financing to encourage renewable energy and climate adaptation investments, and deploying blended finance and public-private partnerships to mobilise private capital for infrastructure and innovation. Dynamic credit guarantee schemes tailored to startups and high-growth SMEs can also nurture entrepreneurship and job creation.
Moreover, adopting macroprudential policies that manage emerging systemic risks such as those from digital finance innovations or climate vulnerabilities will strengthen financial stability in an evolving economic landscape.
Building a future-ready economy also requires strategic prioritisation. Rather than dispersing limited resources across numerous small projects, Nepal must focus on selecting and massively investing in key sectors, ensuring timely completion through coordinated efforts across all levels of government. Extensive stakeholder consultation and learning from past experiences are essential to align policy provisions, human resources and implementation responsibilities toward shared national goals.
Ultimately, embedding innovation, sustainability and inclusive finance principles into Nepal’s monetary policy framework demands stronger coordination between the central bank, government agencies and private sector actors, alongside investments in data, technology and institutional capacity.
Nepal stands at a crossroads: relying solely on traditional monetary levers risks oversimplifying complex development challenges, while embracing transformative, non-conventional approaches offers a path toward resilient, inclusive and sustainable growth. It is time for Nepal to expand its policy toolkit and boldly invest in the future.
Baikuntha Aryal: There is no doubt that Nepal must take leapfrog steps to transform its economy. The conventional approach of interest rate cuts and maintaining sizeable reserves is still valid as long as it incentivises investment and manages international trade. However, these measures only are not enough to attain high economic growth and meet the development aspirations.
The government and NRB need to adopt policies that facilitate the production sector both in goods and services. Less regulation with stringent criteria; timely intervention and adoption of corrective measures; good harmony and coordination in fiscal and monetary implementation; trust building between public and private sectors; legal and procedural reforms; eliminating administrative and procedural hassles; enhancing public and private sector capacity; promoting innovation; promoting and incentivising job creating sectors; and prioritising the leading growth sectors are some policies the government and NRB need to adopt at the earliest.
Overall, Nepal needs stable, forward looking and strong economic bases. The government may, with thorough analysis, immediately identify the leading growth sectors and prioritise them rather than prioritising everything. Focusing on leading sectors may help to transform the economy quicker than prioritising everything.
