Nepal's Financial Dilemma

Daftar Isi

The Paradox of Nepal's Financial System

Nepal's financial system presents a puzzling contradiction: while banks have an abundance of loanable funds, the real economy struggles to access credit. By the first quarter of this fiscal year, banks had over Rs1.1 trillion in available funds—marking one of the largest surpluses in the country’s history. Monthly remittances exceeding Rs200 billion have further increased deposits. Despite this surplus, the credit-deposit ratio remains around 74 percent, industries operate well below capacity, interest rates have dropped to a four-year low, and both households and businesses are hesitant to borrow. This paradox reveals deeper structural issues within Nepal’s economy.

One of the primary causes of this situation is the historically high and volatile interest rates imposed by banks since the onset of the COVID-19 pandemic. At times, these rates reached as high as 20 percent, which severely undermined public confidence and discouraged borrowing. When individuals and businesses lose trust in the financial system, even affordable credit fails to motivate them to take risks. Weak regulations, corruption, and illogical policies from central banks have also contributed to an unstable environment, making it difficult for both banks and businesses to invest in long-term projects.

Monetary policy alone cannot revive an economy with weak structural foundations. In the early 1980s, when China faced inflation of about 25 percent, it chose not to raise interest rates drastically like many Western central banks did. Instead, it implemented supportive fiscal and industrial policies that maintained business competitiveness and confidence. Despite predictions of economic failure by Western economists, China continued to grow at double-digit rates. This example shows that monetary tightening may not always be the right solution for developing economies facing structural bottlenecks, such as those in Nepal.

Nepal is experiencing symptoms of a liquidity trap—a scenario where lower interest rates fail to stimulate borrowing due to a lack of economic confidence. While the Nepal Rastra Bank (NRB) has made some adjustments, such as cutting policy rates and easing rules for overdrafts, these measures do not address the deeper structural constraints that prevent money from flowing into productive investments. For the economy, the cost of money is not the main issue; rather, it is the absence of strong, high-quality, bankable projects that can absorb the liquidity in the financial system.

From the perspective of New Structural Economics (NSE), developed by former World Bank Chief Economist Justin Yifu Lin, monetary policy in developing economies should align with their stages of structural transformation. In countries with abundant labor and underutilized productive sectors, such as Nepal, monetary policy should be development-supportive rather than just a reaction to business cycles. The failure of liquidity to translate into investment points to bottlenecks in infrastructure, logistics, energy supply, and market coordination. When interest rates are low but investment remains stagnant, the real problem is insufficient structural transformation, not a shortage of money.

Coordination failures lie at the heart of Nepal's credit stagnation. Entrepreneurs face challenges in funding promising projects like cold-chain systems, tourism infrastructure, hydropower corridors, and Information & Communication Technology parks. Meanwhile, commercial banks struggle to assess the financial risks of these ventures due to information gaps, poor project preparation, and limited technical capacity. This creates a cycle of hesitation between lenders and borrowers, further slowing economic momentum. Lowering interest rates alone will not resolve these issues. Nepal needs a targeted, risk-reducing approach that guides liquidity into high-return sectors.

International examples offer valuable lessons. Over the past four decades, China has developed a developmental monetary policy that actively directed liquidity towards productive sectors. Starting in the 1980s, the People's Bank of China used "window guidance" to direct credit toward export zones and township industries. In the 1990s, before joining the World Trade Organisation, it pushed more liquidity into industrial clusters and special economic zones. After the 2008 global financial crisis, the central bank introduced large-scale re-lending and re-discount programs to support SMEs, agriculture, logistics, and infrastructure. The 2014 Targeted Medium-Term Lending Facility (TMLF) funneled over RMB one trillion into cold chains, renewable energy, transmission lines, and high-tech hubs.

Similarly, South Korea's use of export-linked refinancing for shipbuilding, electronics, automobiles, and steel enabled companies like Hyundai, Samsung, and POSCO to grow into global giants. Singapore used government risk-sharing schemes and blended financing to expand lending to SMEs and develop world-class logistics, tourism, and digital infrastructure. These cases demonstrate that liquidity becomes productive only when central banks provide strategic direction, reduce risks, and coordinate with other government institutions.

Nepal can adopt similar strategies. The NRB can create sector-specific refinancing windows for agro-processing, cold-chain logistics, hydropower transmission, ICT parks, and tourism infrastructure. Projects strongly aligned with the country’s comparative advantages pose minimal risk and remain viable. These windows must use concessional loans with clear guidelines and government assurance of regional and global value chain relevance. Nepal can also mobilize its annual remittance inflows of over Rs1 trillion through remittance infrastructure bonds, hydro-diaspora funds, and co-investment platforms that channel migrant savings into national development.

The structural roots of Nepal's liquidity crisis are becoming increasingly evident. Remittances have boosted deposits but weakened domestic entrepreneurship as millions of young people continue to migrate abroad for work. Persistent underinvestment in public infrastructure has denied the economy the momentum needed to attract private investment. Political instability and regulatory uncertainty create risk aversion among banks and businesses. Limited information on potential investments prevents promising ideas from becoming bankable projects.

Overcoming these challenges requires Nepal to adopt a liquidity-to-development strategy. This would involve accelerating public capital spending, preparing a pipeline of ready-to-implement projects, strengthening national credit guarantees, mobilizing investment from the diaspora, and guiding liquidity toward high-return productive sectors. Most importantly, the NRB must expand its mandate beyond stability and take on a development-oriented role through targeted refinancing, risk-sharing, and close coordination with the Ministry of Finance and provincial governments. This is not a return to politically driven credit allocation but a correction of market failures that keep Nepal trapped in low productivity, weak exports, and slow growth.