Nepal’s economy is currently facing a peculiar situation: its financial institutions are awash with funds, yet the actual economy is struggling to access credit. In the first quarter of the current fiscal year, banks held over 1.1 trillion Nepalese Rupees (NPR) in loanable funds, marking one of the country’s largest surpluses. This influx is largely due to monthly remittances exceeding 200 billion NPR, further bolstering bank deposits.
However, despite this surplus, the credit-deposit ratio has remained stagnant at around 74 percent. Industries are operating far below their potential, interest rates have plummeted to a four-year low, and both households and businesses are hesitant to borrow. This contradiction points to more profound structural issues within Nepal’s economic framework and its overall direction, requiring immediate and comprehensive solutions.
The Impact of High and Volatile Interest Rates
A primary cause of this situation is the excessively high and fluctuating interest rates imposed by banks since the onset of the COVID-19 pandemic. These rates, at times reaching as high as 20 percent, have significantly eroded public confidence and discouraged potential borrowers from making investments. When businesses, households, and entrepreneurs lose faith in the financial system, even affordable credit fails to incentivize them to take risks.
Contributing factors include:
- Weak regulations
- Corruption
- Illogical policies implemented by the central bank
These elements have collectively created an insecure environment, deterring both banks and businesses from investing in long-term projects.
The Limitations of Monetary Policy
Simply adjusting interest rates is insufficient to revive an economy with fundamental structural weaknesses. China’s experience in the early 1980s, when it faced inflation of around 25 percent, demonstrates this. Instead of drastically increasing interest rates as Western central banks typically do, China implemented supportive fiscal and industrial policies to maintain business competitiveness and confidence. As a result, China continued to achieve double-digit growth rates, defying predictions of economic failure from Western economists. This example illustrates that monetary tightening is not always the optimal solution for developing economies, particularly those grappling with structural bottlenecks like Nepal.
Nepal exhibits characteristics of a liquidity trap, where lower interest rates fail to stimulate borrowing due to a lack of confidence in the economic environment. While the Nepal Rastra Bank (NRB), the country’s central bank, has implemented policy adjustments such as:
- Cutting policy rates
- Easing overdraft rules
- Relaxing deposit restrictions
- Adjusting liquidity management instruments
These measures do not address the underlying structural constraints that prevent money from flowing into productive investments. The core issue is not the cost of money but a scarcity of strong, high-quality, bankable projects capable of absorbing the available liquidity.
The New Structural Economics Perspective
Nepal’s liquidity paradox can be understood through the lens of New Structural Economics (NSE), developed by Justin Yifu Lin, a former World Bank Chief Economist. NSE suggests that monetary policy in developing economies should be carefully aligned with their stages of structural transformation. In countries like Nepal, with abundant labor and underutilized productive sectors, monetary policy should support development rather than merely reacting to business cycles. The failure of liquidity to translate into investment indicates bottlenecks in:
- Infrastructure
- Logistics
- Energy supply
- Market coordination
When interest rates are low but investment remains stagnant, the fundamental problem is insufficient structural transformation, not a lack of funds.
Coordination Failures and the Need for Targeted Approaches
Coordination failures lie at the heart of Nepal’s credit stagnation. Entrepreneurs struggle to secure funding for promising projects in sectors such as:
- Cold-chain systems
- Tourism infrastructure
- Hydropower corridors
- Information & Communication Technology (ICT) parks
Commercial banks, on the other hand, find it challenging to assess the financial risks associated with these new ventures due to:
- Information gaps
- Poor project preparation
- Limited technical capacity
This leads to a “wait and see” approach from both lenders and borrowers, creating a self-reinforcing cycle that further hinders economic progress. Lowering interest rates alone cannot solve these issues. Nepal requires a targeted, risk-reducing approach that directs liquidity towards high-return sectors.
Lessons from International Experience
International experiences offer valuable insights. China, over the past four decades, has developed a developmental monetary policy that actively guided liquidity towards productive sectors.
- In the 1980s, the People’s Bank of China used “window guidance” to direct credit towards export zones and township industries.
- In the 1990s, ahead of its accession to the World Trade Organization (WTO), China channeled 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) allocated over one trillion RMB to 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 from small firms into global giants. Singapore utilized government risk-sharing schemes and blended financing to expand lending to SMEs and develop world-class logistics, tourism, and digital infrastructure. These examples demonstrate that liquidity becomes productive when central banks provide strategic direction, reduce risks, and coordinate with other government institutions.
Strategies for Nepal
Nepal can adopt similar strategies. The NRB can establish sector-specific refinancing windows for:
- Agro-processing
- Cold-chain logistics
- Hydropower transmission
- ICT parks
- Tourism infrastructure
Supporting industries strongly aligned with the country’s comparative advantages poses minimal risk due to their inherent viability. These windows should offer concessional loans with clear guidelines and government assurance of regional and global value chain integration. Nepal can also leverage its substantial remittance inflows, exceeding one trillion NPR annually, through:
- Remittance infrastructure bonds
- Hydro-diaspora funds
- Co-investment platforms
These mechanisms can channel migrant savings into national development.
Addressing the Structural Roots
The structural causes of Nepal’s liquidity crisis are becoming increasingly evident. While remittances have increased deposits, they have also weakened domestic entrepreneurship as millions of young people continue to migrate abroad in search of employment. Persistent underinvestment in public infrastructure has deprived the economy of 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.
A Liquidity-to-Development Strategy
Overcoming these challenges requires Nepal to adopt a liquidity-to-development strategy, which includes:
- Accelerating public capital spending
- Preparing a pipeline of ready-to-implement projects
- Strengthening national credit guarantees
- Mobilizing investment from its diaspora
- Guiding liquidity towards high-return productive sectors
Critically, the NRB must broaden its mandate beyond stability and embrace a development-oriented role through targeted refinancing, risk-sharing, and close collaboration 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 trap Nepal in low productivity, weak exports, and slow growth.
