AT A GLANCE
In 2018, the World Bank came up with its (CPF) covering the five-year period of FY2019-2023. Coincidentally, this came at a time of historic transformation in Nepal, as a new government took up office in February 2018. The signing of the Comprehensive Peace Agreement in 2006 ended a 10-year conflict that came at a significant cost of lives and foregone economic development. Since then, Nepal has gone through lengthy and complex transitions towards a new Constitution in 2015 that set in place a federal structure. By the end of 2017, elections were successfully held at the federal, state, and local tiers. There is a newfound optimism for greater political stability, inclusion, good governance and sustainable growth. The new federal structure presents unprecedented opportunities for Nepal to reset its development storyline, as outlined in the Systematic Country Diagnostic (SCD).
At the same time, the shift to federalism poses new challenges and source of fragility, given the heightened popular aspirations and expectations. Key challenges include the need to clarify the functions and accountabilities of the federal, state, and local governments; deliver basic services and maintain infrastructure development; create a conducive environment for the private sector; and address governance weaknesses that may worsen in the early years of the new federal system.
COUNTRY CONTEXT
In Nepal, the government formed in 2018 was preceded by elections for all three tiers (local, state and federal) of the state architecture defined by the new constitution, marking a protracted but successful conclusion of a political transition that began with the signing of the Comprehensive Peace Agreement in November 2006. State governments largely mirror the coalition at the center. At the sub-national level, funds, functions and functionaries hitherto managed by the central, district and village authorities are moving to the seven new states and 753 local governments for which new legislation, institutions and administrative procedures are being formalized as constitutionally prescribed. Meanwhile, the central level authority is being streamlined with a focus on oversight. These exercises at state restructuring are expected to result in improved outreach and service delivery but will likely take time before they become fully operational.
Significant adjustments need to be made to the government structure. They include amending over 400 existing acts, restructuring the civil service at all levels, devolving fiscal management, and determining the division of funds, functions, and functionaries between various levels of government. State restructuring on this scale is uncharted territory for Nepal and smoothening the transition from the previous unitary system to the new federal one will remain a daunting task. The new system, in principle, provides opportunities to decentralize development benefits and make service delivery more effective and accountable. However, the risks of jurisdictional overlap between the three tiers of government, lack of clarity and coherence between policies and devolved powers, and duplication of efforts will remain high during the coming few years. Key aspects of the new system require further definition and may continue to be contested by different population groups.
RECENT ECONOMIC DEVELOPMENTS
Nepal’s economic growth accelerated in the first half of FY25 (H1FY25). Real GDP grew by 4.9 percent in H1FY25, up from 4.3 percent in H1FY24, primarily due to a pickup in agricultural and industrial sectors growth, though a slowdown in the services sector partially offset this increase. This acceleration occurred despite natural disasters and disruptions in tourism. Floods and landslides caused damage equivalent to 0.8 percent of GDP, severely impacting infrastructure, agriculture, and social services. Furthermore, the ongoing upgrade of Tribhuvan International Airport, initiated in November 2024, led to major disruptions in the tourism sector, with reduced operating hours and increased ticket prices due to the absence of an alternative international airport.
Headline inflation eased to 5 percent in H1FY25, down from 6.5 percent in H1FY24, aligning with the NRB’s inflation ceiling. This decline was mainly driven by reduced non-food and services inflation, particularly in housing, utilities, and restaurant services. However, food and beverage inflation remained elevated at 7.5 percent, with vegetable prices rising by 26.6 percent, despite the FY25 budget’s removal of VAT on select produce.
The current account surplus (CAS) moderated from 2.8 percent of GDP in H1FY24 to 2.4 percent in H1FY25, as declining remittance inflows offset a lower trade deficit. Remittance inflows fell from 12.9 percent of GDP in H1FY24 to 12.4 percent in H1FY25, influenced by a 26 percent reduction in migrant outflows, especially a sharp 74 percent drop in Nepali workers migrating to Malaysia. Meanwhile, the trade deficit narrowed as imports of goods and services reached their lowest level since H1FY16, driven by reduced imports of petroleum products and outbound travel. On the export side,merchandise exports grew, particularly in refined edible oils, and services exports saw a slight decline due to reductions in travel and transport services. Despite the narrowing CAS,Nepal’s foreign exchange reserves remain adequate.
The monetary policy stance remained cautiously accommodative in H1FY25. On July 26, 2024, the central bank reduced the policy rate and the upper bound of the interest rate corridor by 50 basis points each. This followed a series of cuts in FY24, totaling 1.5 percentage points. These reductions, combined with subdued credit demand, led to a significant accumulation of excess liquidity, pushing lending rates to record lows. However, private sector credit declined, largely driven by reduced loans in the deprived sector and working capital loans.
The financial sector faced increasing challenges related to asset quality, profitability, and capital adequacy. The nonperforming loans (NPL) ratio surged to a record 4.9 percent by the end of H1FY25, prompting a rise in loan-loss provisions that eroded sector profitability. In response, the central bank introduced additional forbearance measures, including reducing the countercyclical buffer for FY25 to zero percent from the previous 0.5 percent.
On the fiscal front, the deficit narrowed significantly by 0.5 percentage points of GDP in H1FY25, reaching near balance, driven by stronger revenue growth outpacing slower expenditure increases. The revenue growth was broad-based, with key contributions from higher import-based and domestic excise duties, increased personal income tax revenue driven by higher capital gains, and rising non-tax revenue, particularly from higher dividends from financial and service institutions.
On the expenditure side, a slight decrease was recorded,attributed to lower interest payments on domestic debt, reduced fiscal transfers to provincial and local governments, and lower spending on goods and services.However, capital expenditure remained steady, continuing to be lower than debt servicing expenditure, a trend observed since H1FY22.
OUTLOOK, RISKS, AND CHALLENGES
Nepal’s economy is projected to grow by 4.5 percent in FY25, up from 3.9 percent in FY24, and is expected to average 5.4 percent annually in FY26-FY27. The services sector is expected to be a primary driver of growth, bolstered by a recovery in merchandise imports that will stimulate wholesale and retail trade in FY25. However, disruptions caused by the ongoing upgrade of Tribhuvan International Airport—leading to reduced operating hours—are anticipated to hamper the government’s tourism targets and limit growth in the accommodation and food services sub-sectors for FY25.Over the medium term, though, the airport improvements are expected to provide a positive contribution to the sector.
The industrial sector is forecast to grow robustly in the medium term, largely driven by significant expansions in the electricity and construction sectors. Government efforts to boost electricity capacity and increase energy exports are set to further accelerate industrial growth. Additionally, supportive policies for the construction sector, including extended loan repayment periods and prioritized payments to contractors, are expected to drive activity starting in FY26. Meanwhile, the agricultural sector is projected to grow by 3.2 percent in FY25, supported by higher paddy production due to a favorable monsoon. Assuming continued favorable weather patterns, agricultural growth is expected to rise to 3.3 percent by FY27. Inflation in Nepal is expected to ease, moderating to 5 percent in FY25 and averaging 4.4 percent over FY26-27. This decline will be driven by lower non-food and beverage inflation, reduced production cost pressures, and a positive agricultural output resulting from favorable monsoons in FY26-27. Additionally, lower inflation in India—due to Nepal’s currency peg—will further stabilize prices in Nepal.
The current account surplus is projected to narrow over the medium term, primarily driven by lower remittance and a widening trade deficit. A slowdown in remittance growth is expected in FY25, reflecting the delayed impact of reduced migration in FY24. Nepal’s trade deficit is anticipated to narrow in FY25, as the growth in exports of goods and services, as a share of GDP, outpaces that of imports, before widening in the medium term. Despite these dynamics, foreign exchange reserves are expected to remain at prudent levels, covering approximately ten months of imports by the end of FY27.
The fiscal deficit is expected to stay at 2.5 percent of GDP in FY25, the same as in FY24, as lower revenues (including grants) are expected to be offset by reduced expenditures. The deficit is projected to rise slightly to 2.9 percent of GDP by FY27, driven by higher interest payments and capital spending. Revenue growth will hinge on the successful implementation of the Domestic Revenue Mobilization Strategy. The deficit will be financed through external concessional loans and domestic borrowing, with public debt projected to rise to 43.4 percent of GDP by FY27—remaining within sustainable limits as defined by fiscal regulations.
The risks to Nepal’s economic growth outlook are primarily tilted to the downside. External risks, such as geopolitical uncertainties and rising trade restrictions, could push commodity prices higher. Nepal’s growth model is heavily reliant on remittances and tourism, so a slowdown in partner countries’ growth could result in a decline in both remittances and tourism, further hindering economic growth.
Domestically, further deterioration in financial sector asset quality could tighten private sector credit, while frequent bureaucratic reshuffles could undermine policy consistency. Additionally, Nepal’s continued presence on the FATF Grey List presents a substantial risk to the economy. Another significant domestic risk is the prolonged delay in implementing critical capital expenditure reforms, which could hinder infrastructure development, reduce economic efficiency, and limit longterm growth potential. On the positive side, the economy may benefit from the private sector-led growth reforms introduced through five ordinances passed by Parliament in March 2025.
Last Updated: Apr 03, 2025
