As debt repayment capacity grows, Nepal's dependence on foreign grants dwindles.

The government has been relying on foreign assistance as one of the major sources of financing for its annual budget. Foreign assistance continues to play an important role in Nepal's economic and social development, representing nearly 26% of the national budget.

Development partners--both bilateral and multilateral--have remained largely generous when it comes to providing funds to Nepal.  

For a long time, they provided grants to Nepal considering a 'poor' country to either mobilize its revenue or borrow funds to finance development activities.  

Nepal also prioritized grants over loans from these development partners. However, that trend is now shifting. As Nepal's economic capacity grows, albeit slowly, development partners are now offering loans rather than grants. This shifting trend is also reflected in the annual budget figures of the government.

The government plans to mobilize Rs 59.92 billion in grants and Rs 283.09 billion in foreign loans as part of the sources of financing for its total budget of Rs 1,632.83 billion in the current fiscal year 2021/22. The rest of the other sources of financing are revenues (Rs 1,050.82 billion) and domestic borrowing (Rs 239 billion). The current fiscal year's estimate of sources for financing is in line with the recent shift in the trend of financing the government budget. Earlier in the last fiscal year 2020/21, foreign grants stood at Rs 20.56 billion while the foreign loan was Rs 127.18 billion. This was not the case until the fiscal year 2016/17 when the flow of grants used to outperform foreign loans. In the fiscal year 2015/16, Nepal mobilized Rs 39.55 billion in foreign grants while the foreign loans stood at Rs 34.46 billion.

It's not the external borrowing that is a source of financing. There is a domestic market from which the government can raise debt. However, the government prefers external debt over domestic borrowing as raising debts from the internal market risks crowding out the private sector. Similarly, foreign loans also help in shoring up the foreign currency reserves for the country that has to import capital-intensive goods and machinery required for the development.  

This shift has also led to a rapid rise in Nepal's total public debt level over recent years. According to the data, Nepal's public debt--including both domestic and external debts--has gone up to 46.7% of GDP in the fiscal year 2020/21 from 25% in the fiscal year 2016/17, according to a recent debt sustainability analysis by the International Monetary Fund and the World Bank. However, the total public debt is still considered to be at low risk of debt distress.  

This is due to Nepal's reliance on grants to finance public expenditure over loans. As Nepal tapped the concessional loans offered by bilateral and multilateral development partners, the risk of external debt distress remained very low.

Most of the multilateral development partners have already stopped providing grants to Nepal citing improvement in Nepal's loan repayment capacity. The World Bank Group, Asian Development Bank and International Monetary Fund (IMF) are the largest multilateral development partner in Nepal. A significant portion of the financing in Nepal is loans. The United States of America, the UK, India, China, and Japan are the biggest bilateral development partners in Nepal. However, bilateral partner financing is a mix of grants and loans.

Government officials say that they have also observed the effectiveness of loans in development projects. According to them, loans tend to get aligned with the national priorities as it is mobilised through the treasury and budgetary system while donors' interests tend to prevail over the grant. They say it's the projects financed through grants that face duplication and fragmentation.

Though loans' share in international assistance is increasing, the government is still enjoying favorable borrowing terms. The loans that the government has been borrowing come with negligible or cheap interest rates along with a long repayment period. For example, Japan is providing Nepal Rs 15.28 billion in loans for Nagdhunga Tunnel Construction Project with the condition of 40 years of repayment and 10 year grace period with 0.01% interest annually.   

Once Nepal graduates to developing country status of UN and the World Bank's low-income country, the share of the grants will go down further. Nepal is scheduled to graduate from the least developed country status in 2026 while the country hopes to become a middle-income country by 2030.

Debt Risks
There are also concerns about growing debt burdens. However, the low level of debt that Nepal has maintained over the years is also a reflection of Nepal's economic underperformance and lower growth trajectory. However, if the country wants to accelerate its economic growth and achieve various ambitions like meeting Sustainable Development Goals and becoming a middle-income country by 2030, it has to make sure that its resource envelope also gets increased. While there is ample space to expand domestic revenue, they are not enough sources to meet the growing demand for financial resources.

The country cannot attain its development ambition through grants or concessional loans, either. It is good to expect grants or concessional loans, but they are not enough to propel the country towards a high-growth trajectory. The government cannot get a large grant like $500-million grant more often offered by the US recently under its aid agency Millennium Challenge Corporation (MCC).   

Sooner or later, Nepal must be prepared to reach foreign markets to raise debt to finance its large-scale investments. This is a need that the government has also recognized in its International Development Cooperation Policy introduced in 2019. According to the policy, the Government can mobilize commercial loans for mega projects of national priority having commercial viability with a high financial rate of return.

Not only the commercial loans, the loans offered by some development partners are also going to rise in the days to come as Nepal's repayment capacity increases further. Loans that China offers under the Belt and Road Initiative (BRI) that Nepal has signed up also come with a higher interest rate with a shorter payback period.

While Nepal cannot avoid debt if it wants to achieve its development aspiration and unleash its growth potential, the government must tread carefully when it comes to mobilisation of commercial loans. From the selection of projects to finance through commercial borrowing to utilisation of the fund, the government has still a lot to do to ensure that the external debt should not be a burden for the country or a source for the economic crisis. If mobilised and managed prudently, the external debt can propel Nepal to the path of higher growth, development, and prosperity.