Key Takeaways
- The IMF’s austerity prescription is fundamentally mismatched with Nepal’s economic illness. It is a remedy for a demand-driven overheating economy, whereas Nepal suffers from supply-side stagnation and imported, cost-push inflation.
- Nepal’s Small and Medium Enterprises (SMEs), the backbone of the real economy, are caught in a liquidity trap created by austerity-linked tight monetary policy. Their inability to access working capital is actively suppressing growth, job creation, and tax revenue.
- A strategic policy pivot is inevitable. The Ministry of Finance will likely be forced to defy conventional fiscal discipline and adopt a “growth-first” sovereign debt strategy, prioritizing domestic stimulus and accepting higher short-term inflation as a necessary trade-off for long-term economic revitalisation.
Introduction
There is a dangerous disconnect in Kathmandu’s economic discourse. On one front, there is the official narrative, celebrated in the halls of Singha Durbar and echoed by international donors: a story of fiscal discipline, monetary prudence, and a steady march toward macroeconomic stability. This narrative is backed by the powerful logic of institutions like the International Monetary Fund (IMF), which reward countries that tighten their belts. Yet, on the ground, in the industrial corridors of Birgunj, the tech hubs of Lalitpur, and the myriad workshops that form the nation’s economic bedrock, a different, more troubling story is unfolding. It is a story of choked credit lines, vanishing orders, and a pervasive sense of stagnation that belies the optimistic official data.
This article argues that the very policies designed to secure Nepal’s economic health—specifically, the austerity measures championed as prerequisites for international financial support—are perversely stifling the most vital segment of our economy: the Small and Medium Enterprise (SME) sector. We are witnessing a classic policy tension between satisfying external donor conditions and answering the urgent domestic need for stimulus. The standard IMF playbook, effective in curbing demand-pull inflation in overheated economies, is proving to be a toxic prescription for an economy like Nepal’s, which is grappling with cost-push inflation and severe supply-side bottlenecks. The core counter-intuitive truth is this: a dose of what the IMF fears most—a measured, strategic expansion of government spending—is precisely what the Nepali economy needs to break free from its current low-growth equilibrium.
The analysis that follows will dissect this tension, explaining the mechanisms through which fiscal consolidation and tight money are incapacitating our SMEs. We will then explore the strategic dilemma this creates for policymakers, drawing lessons from regional neighbours. Finally, we will conclude not with a list of recommendations, but with a strategic outlook: a forecast that the Ministry of Finance will, out of political and economic necessity, pivot towards a “growth-first” sovereign debt strategy. This pivot will risk short-term inflation and donor displeasure, but it represents a calculated gamble on long-term national economic sovereignty and stability.
The Anatomy of the SME Suffocation
To understand the current crisis, one must look beyond headline GDP numbers and focus on the circulatory system of the economy: credit and working capital. For Nepal’s SMEs—which collectively contribute an estimated 22% to GDP and provide employment to over 1.7 million people—access to finance is not a tool for expansion, but the very oxygen needed for survival. The current policy environment, heavily influenced by the doctrine of fiscal restraint, is systematically cutting off this oxygen supply through a two-pronged assault: government spending cuts and a restrictive monetary policy.
First, consider the impact of fiscal consolidation. In economic terms, this means reducing the budget deficit by cutting public expenditure and increasing taxes. While this sounds prudent, its immediate effect is a sharp contraction in aggregate demand. When the government shelves a road-building project, it is not just the large construction conglomerate that suffers. It is the local quarry that supplies the gravel, the small logistics firm that transports materials, the workshop that fabricates steel reinforcements, and the local eateries that feed the workers. Each of these is an SME. The government, as the single largest purchaser of goods and services, sets the tempo for the entire domestic economy. Its self-imposed spending freeze creates a vacuum that private consumption, in its current weakened state, cannot fill.
The second, more insidious mechanism is the impact of tight monetary policy enforced by the Nepal Rastra Bank (NRB), often as a tacit condition for demonstrating “discipline” to international bodies. By maintaining high interest rates and enforcing strict credit-to-deposit ratios, the NRB aims to curb inflation and prevent capital flight. However, the result in an SME-dominated economy is a severe credit crunch. Commercial banks, facing pressure to maintain liquidity buffers and de-risk their portfolios, naturally retreat from the perceived high-risk, low-ticket-size world of SME lending. They find it far safer and more profitable to finance a handful of large import-trading houses or invest in government bonds than to underwrite a hundred smaller loans for manufacturing or service businesses. This creates a liquidity trap specifically for SMEs. A small furniture manufacturer in Hetauda may have a full order book from Kathmandu retailers, but if they cannot secure a working capital loan to purchase timber and pay their artisans, those orders go unfulfilled, workers are laid off, and economic activity ceases. This is not a theoretical problem; it is the daily reality for thousands of entrepreneurs who are being told credit is “available” but find it perpetually out of reach.
This dynamic reveals a fundamental flaw in applying a one-size-fits-all austerity model to Nepal. The policy assumes that squeezing liquidity will cool an overheating economy. But Nepal’s economy is not overheating; it is seizing up. The SMEs are not speculative borrowers fuelling an asset bubble; they are productive enterprises being starved of the capital they need to meet existing demand. By treating a supply-side ailment with a demand-side suppressant, we are not curing the patient; we are inducing a coma.
The IMF Playbook vs. Nepal’s Ground Reality
The allure of the IMF’s Extended Credit Facility (ECF) and similar multilateral support packages is undeniable for a resource-constrained nation like Nepal. They offer a vital source of foreign currency, bolster reserves, and provide a “seal of approval” that can attract foreign direct investment. However, this support comes with a standardised set of policy conditionalities, a “playbook” honed over decades in diverse global crises. The critical strategic error is failing to recognise that this playbook was written for a different game than the one Nepal is currently playing.
The classic IMF intervention is designed for countries experiencing a balance of payments crisis driven by demand-pull inflation. This scenario typically involves a government running massive fiscal deficits, financed by printing money, which leads to an “overheating” economy where too much money chases too few goods. In this context, the IMF prescription makes perfect sense: cut government spending (fiscal consolidation), raise interest rates to make borrowing more expensive (monetary tightening), and devalue the currency to make exports cheaper and imports more expensive. The goal is to violently contract domestic demand to restore macroeconomic balance.
Now, map this onto Nepal’s current situation. The diagnosis is profoundly wrong on at least three counts. First, Nepal’s inflation is not primarily a demand-pull phenomenon. It is overwhelmingly cost-push and imported. The primary drivers of the recent price surges have been global commodity prices (especially fuel and fertilisers), supply chain disruptions inherited from the pandemic and geopolitical conflicts, and the high indirect taxes levied by the government itself on imported goods. Squeezing the purchasing power of Nepali consumers and businesses does virtually nothing to control the price of Brent crude or urea. It merely forces families and firms to cut back on other expenditures, deepening the economic slowdown and creating the toxic cocktail of stagflation—stagnant growth combined with high inflation.
Second, the core assumption that the economy is “overheating” is demonstrably false. Private sector credit growth has plummeted to its lowest levels in years. Capital expenditure by the government is chronically underspent, not overspent. Industrial capacity utilisation remains stubbornly low. These are all symptoms of an economy that is anemic and sputtering, not one running a high fever from excessive demand. Applying demand-suppression policies in this environment is akin to putting a patient on a crash diet to cure malnutrition.
Third, the IMF model implicitly assumes a formalised, interest-rate-sensitive economy. In Nepal, where the informal sector accounts for a vast portion of economic activity and employment, policy transmission mechanisms are weak and unpredictable. A 100-basis-point hike in the policy rate may deter a large corporation from taking on a new capital loan, but its primary effect on the vast majority of micro and small enterprises is simply to make it impossible for them to service existing debt or access any new credit at all. These businesses operate on cash flow, not sophisticated financial modelling. The policy lever that truly moves them is not the interest rate, but the general level of demand in the economy and the direct availability of credit from a banking sector that is willing to lend to them. The current policy mix fails on both counts.
The Sovereign Debt Dilemma: A Lesson from Two Neighbours
Faced with a stagnating economy and an ineffective policy toolkit, Nepal’s policymakers are approaching a critical inflection point. The choice is no longer simply about adhering to fiscal targets; it is about selecting a fundamental strategy for managing sovereign debt and national growth. Broadly, two paths diverge. The first is the “stability-first” path advocated by the IMF, which prioritizes reducing the debt-to-GDP ratio through immediate fiscal austerity. The second is the “growth-first” path, which involves a deliberate, temporary expansion of the fiscal deficit to stimulate the economy, with the strategic wager that the resulting GDP growth will ultimately make the debt burden more manageable in the long run.
To understand the profound risks and potential rewards of this choice, we need not look further than our own region. Sri Lanka serves as a harrowing cautionary tale of a growth-first strategy gone disastrously wrong. Colombo pursued an ambitious, debt-fueled infrastructure and stimulus program. The fatal error, however, lay in the composition of this debt. It was overwhelmingly financed by external borrowing in foreign currencies (US dollars). When their primary sources of foreign currency—tourism and remittances—collapsed during the pandemic, and their profligate tax cuts decimated government revenue, they found themselves unable to service their dollar-denominated debts. This led to a sovereign default, a currency collapse, and hyperinflation. The Sri Lankan lesson is clear: a growth-first strategy funded by external, hard-currency debt is a direct path to ruin for a country without a robust and diversified export base.
In stark contrast, consider the case of Bangladesh. Over the past two decades, Bangladesh has also pursued an aggressive growth-first model, investing heavily in infrastructure and energy. It, too, has seen its public debt rise. However, it has largely avoided the Sri Lankan trap for two key reasons. First, a significant portion of its development has been underwritten by a phenomenal export engine—the Ready-Made Garment (RMG) industry—which provides a continuous and massive inflow of foreign currency. Second, a substantial part of its public borrowing has been domestic, sourced from its own banking system and denominated in its own currency, the Taka. A government can never technically default on debt issued in its own currency; the risk is not default, but inflation, as the central bank may be pressured to print money to finance the deficit.
This comparative analysis provides a clear strategic map for Nepal. A Sri Lanka-style dash for growth funded by international bond markets is off the table and would be suicidal. However, a modified, Nepal-centric version of the Bangladeshi model is conceivable. Nepal lacks a single, world-beating export industry like RMG. Therefore, our “growth-first” strategy cannot be externally oriented. It must be internally focused. The path forward involves financing a targeted fiscal stimulus—focused on completing last-mile infrastructure projects and providing direct support to productive SMEs—primarily through domestic borrowing. This means issuing more government bonds to be purchased by Nepali banks, pension funds, and insurance companies. The primary risk, therefore, is not a foreign currency crisis, but a classic “crowding out” of private investment and a surge in domestic inflation. This is the precise trade-off the Ministry of Finance must now weigh.
The Strategic Outlook
The tension between the austerity-driven official narrative and the reality of a suffocating SME sector is becoming politically and economically untenable. The Ministry of Finance and the NRB cannot indefinitely maintain a policy stance that achieves paper-thin macroeconomic stability at the cost of genuine economic vitality. Therefore, a policy pivot is not a matter of ‘if’ but ‘when’ and ‘how’. The most probable scenario is a subtle but decisive shift away from IMF-orthodoxy towards a pragmatic, “growth-first” domestic stimulus strategy over the next 12 to 18 months.
This pivot will not be announced in a grand press conference. It will manifest through a series of coordinated, technical manoeuvres. Expect to see the Ministry of Finance accelerate capital expenditure, even if it means breaching the announced fiscal deficit target. The justification will be the urgent need to boost job creation and complete nationally vital projects. Simultaneously, the NRB, likely under guidance from the government, will begin to cautiously inject liquidity into the banking system. This may come through a relaxation of the credit-to-deposit ratio, the introduction of targeted refinancing schemes for agriculture and SMEs, or a more lenient interpretation of loan-loss provisioning norms to encourage banks to lend again. The explicit goal will be to break the credit logjam that is strangling small businesses.
The immediate and unavoidable consequence of this coordinated fiscal and monetary stimulus will be inflation. With more money chasing a limited supply of goods and services, and with our heavy reliance on imports, prices will rise. The Nepali Rupee may face depreciatory pressure against the US dollar. This is the high-wire act. The strategic bet being made by policymakers is that this inflationary cost is a temporary price worth paying. The wager is that the stimulus will reignite the SME engine, which will, in turn, create jobs, increase disposable incomes, and boost domestic production. This revitalised economic activity will broaden the tax base, increasing government revenue. Over the medium term, the goal is for GDP (the denominator) to grow faster than the national debt (the numerator), thus bringing the debt-to-GDP ratio down organically, through growth, rather than artificially, through austerity.
The Hard Truth: There is no painless option on the table for Nepal. The choice is a grim one between the slow, grinding stagnation of continued austerity and the inherent volatility of a growth-first stimulus. The former promises stability but delivers despair; the latter offers a chance at prosperity but courts the risk of inflation. Given the immense pressure for job creation, the constraints of electoral cycles, and the visible decay in the real economy, the political calculus overwhelmingly favours action over inaction. Nepali business leaders, investors, and CEOs should therefore recalibrate their strategies. The era of deflationary pressure and tight credit is drawing to a close. The next phase of Nepal’s economy will likely be characterised by higher inflation and higher interest rates, but also, critically, by a revival in domestic demand and greater opportunities for businesses that can effectively cater to a stimulated local market. Prepare for the high-wire act to begin.
