Nepal at the Crossroads: Political Volatility, Economic Fragility, and the Prospect of Stability

By Arun Dahal Khatri

Nepal’s parliamentary elections of November 2022 marked another chapter in the country’s long journey of political instability, setting the stage for its fragile transition toward federalism. After decades of monarchy, civil conflict, and uncertain democratic experiments, the country remains deeply polarized between two coalitions: the communist parties on one side and the Nepali Congress on the other. While the contest between these forces has dominated politics, the greater cost has been borne by the economy, where opportunities for reform and modernization are repeatedly sacrificed to the imperatives of short-term coalition survival. Since December 2024, an unusual coalition between the communists and the Nepali Congress has governed the country under a fragile agreement to rotate leadership until the 2027 general election, an arrangement that has brought temporary calm but not structural stability. The political story is important because Nepal’s economy, already fragile, has been defined as much by external shocks as by internal paralysis. Tourism and remittances remain the two largest sources of foreign exchange, yet both have proved volatile. The civil war years and the later earthquake shocks weakened the economy, while the Covid-19 pandemic left deep scars, particularly in services. However, the past two years brought modest recovery, with GDP growth reaching 4 percent in 2024. Agriculture exports rose, rice production improved, and tourism revenues jumped by more than 30 percent compared to the previous year. Hydropower capacity grew by more than 450 megawatts, an important development in a country with vast untapped water resources. Remittances, too, reached record levels in 2023, underpinning household consumption and helping stabilize the external account. These figures suggest an economy trying to heal, but underneath the surface, the weaknesses remain profound.

The most striking problem is the decline in both private and public investment. Imports of intermediate and capital goods have weakened, reflecting poor business confidence and low domestic demand for expansion. The government’s execution of capital expenditure is consistently poor, with austerity measures cutting into already insufficient infrastructure spending. Although the fiscal deficit fell to its lowest point in seven years, this came at the expense of capital investment that could have stimulated growth. The state remains dependent on donor aid and concessional loans, but here too, the outlook has dimmed. With U.S. President Donald Trump halting foreign aid programs, Nepal will need to turn more heavily to India and China to sustain external support, a shift that risks deepening its reliance on neighbors for critical development finance.

In this context, the entry of Nepal’s Gen-Z into politics carries economic importance. The youth-led protests of 2025 september 8  were fueled not only by anger at corruption and mismanagement but also by economic frustrations. Unemployment remains high, underemployment is widespread, and emigration continues to drain the most ambitious youth to labor markets abroad. The protests forced the government to acknowledge young people’s demands and opened doors for some leaders of the movement to enter policymaking. This integration of youth voices has raised hopes of reform and renewal, though entrenched party structures still dominate decision-making. If these younger voices gain greater influence, they may help push forward overdue economic reforms, but so far their presence has been more symbolic than transformative.

While the political class remains divided, the economic reality is that Nepal’s growth path depends on external balances and structural reforms. Since 1976, the country has borrowed from the IMF nine times to cover balance of payments crises. The most recent Extended Credit Facility of $372 million launched in 2022 is nearing its expiration, with the IMF expressing concern about underperformance. The Fund has warned about slow project execution, weak fiscal mobilization, and a fragile banking system. Indeed, the financial sector is under stress: nonperforming loans reached a record 4.9 percent by the first half of FY25, forcing banks to expand provisions and eroding profitability. The central bank, responding to these pressures, reduced the countercyclical buffer to zero, down from 0.5 percent, offering temporary relief but at the cost of longer-term resilience.

Monetary policy has tried to walk a fine line between supporting growth and preserving stability. On July 26, 2024, the Nepal Rastra Bank cut its policy rate and the ceiling of the interest rate corridor by 50 basis points, following a series of cuts totaling 1.5 percentage points during FY24. The aim was to stimulate borrowing and investment, but the outcome was muted. Instead of a credit expansion, excess liquidity piled up in the system. Lending rates fell to record lows, but demand for loans, particularly in working capital and deprived sectors, declined. The paradox of cheap credit amid low investment highlights structural weaknesses in Nepal’s private sector: businesses lack the confidence to invest in an environment marked by political uncertainty, bureaucratic inefficiency, and limited market opportunities.

At the same time, foreign direct investment inflows remain disappointingly low. Despite vast opportunities in hydropower, tourism, and agriculture, foreign investors are deterred by policy inconsistency, frequent regulatory changes, and weak enforcement of contracts. Recent political unrest, capped by the Gen-Z protests and outbreaks of violence against major businesses, has reinforced a sense of risk. Foreign firms witnessed the burning of outlets belonging to the Hilton Hotel chain and Nepal’s own retail giant, Bhatbhateni, during protests, events that underscored how fragile investor confidence remains. The pessimism around FDI not only limits job creation and technology transfer but also keeps Nepal reliant on remittances as the main external stabilizer, a dependence that leaves the economy vulnerable to shocks in labor-receiving countries. Despite these difficulties, Nepal’s external position shows one silver lining: foreign exchange reserves remain higher than external debt obligations, a rare strength for a low-income country. By the end of FY25, reserves are projected to cover around ten months of imports, a comfortable buffer that provides policymakers with some breathing space. This condition means that unlike Sri Lanka, Nepal is unlikely to face imminent insolvency. The challenge, however, is to convert this reserve strength into long-term productive investment that can reduce reliance on aid and remittances.

On the fiscal side, there are modest signs of improvement. The fiscal deficit narrowed in the first half of FY25 by 0.5 percentage points of GDP, nearly balancing, as revenue growth outpaced slower expenditure. Import duties, excise revenues, and personal income taxes all rose, with the latter boosted by capital gains. Non-tax revenues also increased, particularly from dividends of financial and service institutions. Expenditure decreased slightly, owing to lower interest payments on domestic debt, reduced transfers to provincial governments, and cuts in goods and services spending. Yet capital expenditure, the type of spending most critical for long-term growth, remained insufficient and continued to trail behind debt servicing. This structural imbalance highlights Nepal’s fiscal dilemma: revenues are growing, but the state is still unable to spend effectively on development.

Looking forward, Nepal’s economy is projected to grow by 4.5 percent in FY25, up from 3.9 percent in FY24, and to average 5.4 percent in FY26 and FY27. Services will drive much of this expansion, supported by rising imports that stimulate trade activity. However, disruptions caused by upgrades at Tribhuvan International Airport, reducing operating hours, will hamper tourism in the short run. Over the medium term, improved airport infrastructure is expected to benefit the sector, but in the near term, growth targets will likely fall short. Agriculture should expand by around 3.2 percent in FY25, aided by favorable monsoons, while hydropower and construction will anchor industrial growth. With India agreeing to import 10,000 megawatts of electricity over the next decade, hydropower exports could help reduce the trade imbalance if implemented effectively.

Inflation, meanwhile, is set to ease from 5.4 percent in 2024 to 5 percent in FY25 and average 4.4 percent in FY26–27. This moderation will come from falling non-food inflation, lower production cost pressures, and favorable agricultural output. Because Nepal pegs its currency to the Indian rupee, lower inflation in India will also support stability in domestic prices. The current account, which recently moved into surplus due to record remittances, is expected to narrow in the medium term as remittance growth slows and the trade deficit widens again. Even so, reserves are projected to remain strong, continuing to cover roughly ten months of imports through FY27.

The risks to this outlook are considerable. Externally, geopolitical uncertainty, trade restrictions, and rising commodity prices could destabilize Nepal’s fragile balance. Domestically, continued stress in the banking sector may constrain credit further, while frequent bureaucratic reshuffles erode policy consistency. Nepal’s presence on the FATF Grey List threatens to undermine financial credibility, complicating cross-border transactions and deterring investors. The failure to implement capital expenditure reforms could prolong infrastructure bottlenecks and drag on growth potential. Yet the opportunities are equally visible. If the current coalition manages to maintain stability through 2027, and if the voices of Nepal’s younger generation are integrated into governance more substantively, the political environment could stabilize enough to attract investment. Foreign reserves already provide a cushion, hydropower exports could become a reliable revenue stream, and remittances, while slowing, will continue to support consumption. A stable government that commits to capital expenditure reform and policy continuity could finally unlock Nepal’s long-discussed but unrealized potential.

For now, the country stands at a crossroads. The combination of fragile governance, youth activism, cautious monetary easing, financial sector stress, and FDI pessimism paints a picture of both danger and opportunity. Nepal is neither collapsing nor surging ahead. Its economy continues to move in fits and starts, constrained by politics but sustained by its people, who continue to send remittances home, work the land, and hope for a better tomorrow. If the political elite can overcome their divisions, the next decade could see Nepal finally chart a stable path toward prosperity. If not, the cycle of fragile growth and fragile governance will persist, leaving the nation’s vast potential unrealized.