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A potential debt trap in Nepal

Nepal might risk falling off a debt cliff if proper spending on infrastructure and the quality of governance is not improved. : Laurentiu Morariu (Unsplash) Unsplash License Nepal might risk falling off a debt cliff if proper spending on infrastructure and the quality of governance is not improved. : Laurentiu Morariu (Unsplash) Unsplash License

If the government of Nepal is not too careful with debt diplomacy, it might face a similar fate to Sri Lanka and Pakistan.

The deadly plane crash in Pokhara which killed all 72 people on board put the spotlight on the nearby international airport. The airport was built with assistance from China through the Belt and Road Initiative and has been controversial due to confusion over its financing. 

It is alleged that through the Initiative, China’s debt diplomacy could be converted into ‘debt trap diplomacy, which involves sponsoring significant infrastructure projects in developing countries with unsustainable loans and then exploiting the debt to exert influence over those governments. 

Aside from the Pokhara International Airport, Nepal has just completed the construction of two major projects Gautam Buddha International Airport at Bhairahawa and Chobhar Dry Port in the capital, Kathmandu. 

None of these expensive projects have been operating effectively. If a project’s business strategy is ineffective or established without rigorous preparation, it conveys a very negative message to the international community and future generations. This is why extreme caution is required when funding such projects with borrowed money. The quality of governance is another issue to be seriously considered while racking up debt.

The risk here is that a country’s national debt could become too high when Nepal needs heavy investment in quality infrastructure. When that happens, spending without proper calculation of income or direct contribution to the national output can be disastrous. As a result, increased interest payments can divert funds from other much-needed government projects, or there is a less private investment because of high-interest rates. Budgets are tightened and confidence in the economy weakens.

For the fiscal year 2022–2023, Nepal’s government is only permitted to raise a maximum of 256 billion Nepalese Rupees (about  USD$ 2 billion) in internal loans. The decision to limit external borrowing comes at a time when several countries, including Sri Lanka, were facing debt distress. 

Despite Nepal’s debt level, which has doubled to 2 trillion Nepalese Rupees (from USD$7 billion to USD$15 billion) in 2018-19, it still has room to increase foreign debt acceptance by around 12 per cent. This has tripled in almost six years. Nepali officials have also become more cautious in accepting loans from China, requesting grants instead of loans for projects under the Belt and Road Initiative. 

Governments often face uncontrolled government debt due to factors such as recessions, high military spending, social spending and a fall in tax revenue. There are various ways to deal with this, usually by reducing government spending which means cutting programs or raising taxes. Nepal’s main source of revenue is import duties which means it’s forced to take on debt to finance development.  The risk, as research suggests, is that debt spent with poor governance can further inhibit economic growth.

On top of this, high debt can lead to inflation as the government may be tempted to print more money to pay off its debts, decreasing the value of its currency. This can hurt exports and decrease the standard of living for citizens, who are now facing higher prices for goods and services. 

In extreme cases, the country may even face a debt crisis and require a bailout from the international community, further eroding its economic and political independence. The government’s capacity to respond to upcoming economic shocks, such as a national and international recession or natural disaster like the 2015 Gorkha earthquake is also hampered by a high national debt level because it may lack the resources to finance a stimulus package or necessary investments to maintain daily lives of the people. 

Rational and responsible spending and borrowing strategies are essential while the national economy is still recovering from two global shocks — the COVID pandemic and the Ukraine-Russia war.

If the quality of governance and political instability remain the same, any additional debt burden should be avoided, or proper spending capacity and the quality of governance improved. Otherwise, Nepal could fall off a debt cliff.

Dr Ramesh Paudel is an Associate Professor of Economics at the Central Department of Economics, Tribhuvan University, Kathmandu, Nepal. Ramesh’s interest in research includes but does not limit to macroeconomic variables’ impact on the economy, issues of landlocked economies, structural transformation, foreign direct investment, human development issues and other aspects of development economics.

Additional reporting and contribution by Subin K.C. Subin is a postgraduate student at the Central Department of Economics, Tribhuvan University.

An earlier version of this article had the term ‘debt trap diplomacy’ in the abstract. This has been altered to ‘debt diplomacy’.

Editors Note: In the story “Governments in the red” sent at: 27/02/2023 14:11.

This is a corrected repeat.

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Ramesh Paudel
Tribhuvan University

Shahirah Hamid
Commissioning Editor, 360info Southeast Asia

Chris Bartlett
Senior Commissioning Editor, 360info Asia-Pacific

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